Does Trough Earnings = Peak Stock Prices?

Posted On August 26, 2016 12:08 pm

In recent articles I’ve discussed how the world of ZIRP/NIRP (for the uninitiated that stands for Zero (Negative) Interest Rate Policy) has distorted pricing of not only the bond market but has bled over to all other asset classes.

The most impactful for everyday investors has been the inflated valuation of dividend payers, such as utilities and consumer staples highlighted in this article, and warning once interest rates normalize these stocks are very vulnerable to sell-off.

Most of the recent market gains have been attributable to p/e or multiple expansion on the theory that Q2 represented trough earnings. That is, after 5 consecutive quarters in which the S&P 500 stocks posted a decline in both top and bottom line we might finally be see an upturn in profits and sales. The belief we had reached trough earnings has justified the recent multiple expansion and higher stock prices.

But with most rational people begging for the Yellen and company to hike another measly 25 basis points it begs the question; “Would a rise in rates pinch corporate profits and leave stock valuations, currently with the S&P 500 trading at 19.2x 2017 estimates, vulnerable if earnings fail to climb?”

Roughly two-thirds of the companies in the S&P 500 Index have now reported their latest quarterly earnings. And while the headlines are filled with companies continuing to “beat” expectations, the reality is the downward revisions in corporate earnings are even worse than what this stock market bear expected this quarter. The readings for the latest week have almost assured corporate earnings are going to fall short of the reasonable targets set at the beginning of the quarter.

However, the only reason companies are currently beating estimates is because those estimates had been dramatically lowered since the beginning of this year, turning earnings season into a “participation event.” In other words, if you lower the bar enough, eventually everyone “gets a trophy.”

The chart below shows the evolution of earnings expectations since March of 2015, to present with the bottom part of the chart showing forward estimate changes from January, 2016.

Forward earnings image 8.24.18

As an article in ZeroHedge noted, “While earnings are set to decline again this quarter, which will push valuations even further into the proverbial stratosphere, the real risk to watch is the US Dollar. While Central Banks have gone all in, including the BOJ with additional QE measures of $100 billion, to bail out financial markets and banks following the ‘Brexit’ referendum, it could backfire badly if the US dollar rises from foreign inflows.  A stronger dollar will provide another headwind to already weak earnings and oil prices in the months ahead.”

Unlike the stock market which is pushing extreme overbought levels, the dollar is at an extreme oversold condition and has only started a potential move higher. This is something to pay very close attention to in the months ahead.

Earnings forecaste 8.26.16

Let’s look at a much simpler graphic that makes clear the trend that consensus estimates have a long history of being overly optimistic at the beginning of the year only to be forced to ratchet them down as the year goes on. I expect the same trend to occur for the back half of 2016.

EPS Forecasts 8.25.16

With interest rates negative in many areas of the world, the push of capital into the U.S. for a higher return on reserves is very likely which will continue to suppress earnings and economic growth.

All of this continues to present an increasing dilemma for an already richly valued stock market trading at all-time highs. For with each passing day, stocks are becoming more expensive even if they simply stand still.

Bottom Line: Stocks are vulnerable to a decline if rates rise or earnings don’t continue to recover. And one could lead to the other, creating quite the conundrum for investors.

About author

Steve Smith

Steve Smith have been involved in all facets of the investment industry in a variety of roles ranging from speculator, educator, manager and advisor. This has taken him from the trading floors of Chicago to hedge funds on Wall Street to the world online. From 1987 to 1996, he served as a market maker at the Chicago Board of Options Exchange (CBOE) and Chicago Board of Trade (CBOT). From 1997 to 2007, he was a Senior Columnist and Managing Editor for TheStreet.com, handling their Option Alert and Short Report newsletters. The Option Alert was awarded the MIN “best business newsletter” in 2006. From 2009 to 2013, Smith was a Senior Columnist and Managing Editor for Minyanville’s OptionSmith newsletter, as well as a Risk Manager Consultant for New Vernon Capital LLC. Smith acted as an advisor to build models and option strategies to reduce portfolio exposure and enhance returns for the four main funds. Since 2015, he has worked for Adam Mesh Trading Group. There, he has managed Options360 and Earning 360, been co-leader of Option Academy, and contributed to The Option Specialist website.