Corporate America’s Earnings Boom Bolsters the Bull

Q2 earnings season is winding down, with 459 S&P 500 companies so far reporting pretty good quarterly results and likely more to come. Many pooh-pooh these reports, citing various yah-buts, but^[i] this mostly shows sentiment continues weighing on expectations—bullish, in our view, because it provides a low hurdle for reality to clear.

Despite a solid quarter, with most companies exceeding analysts’ consensus forecasts, many—including corporate executives—continue talking earnings down. Q2 earnings for the S&P 500 rose 24.6% y/y, just a shade lower than Q1’s 24.8%.^[ii] Moreover, this is well up from forecasts for 19% y/y growth before reporting started—which tends to happen when 79% of company announcements beat analyst expectations—a decade high.^[iii] On a sector basis, all 11 sectors reported growth (and all beat expectations, except for Energy), demonstrating Corporate America’s earnings power is not only broad-based, but also underappreciated.^[iv]

Earnings coverage was tinged with tariff talk as analysts attempted to quantify their effects and executives tried to set (low) expectations. But for all the hoopla, quarterly results suggest little impact to date—which isn’t surprising! Tariffs are tiny and relatively easy to work around. In our view, tariffs are a convenient scapegoat—for both analysts and corporate executives. Analysts can blame them in case (or, maybe more cynically, when) their estimates prove off target. Executives can use them to massage those expectations for future quarters lower—making them easier to clear. Tariffs just happen to be the get-out-of-jail-free card ^[v] du jour, considering the weather, currency swings, labor disputes and such may not be as convincing presently.

As in Q1, tax cuts helped provide an earnings boost, but revenues—unaffected by taxes—were also strong, underpinning Corporate America’s vigor. S&P 500 revenues rose 9.9% y/y in Q2—the most since Q3 2011—accelerating from Q1’s 8.5%.^[vi] Sales also exceeded expectations. When earnings season started, they were forecast to rise only 8.7% y/y. Further, 72% of companies reporting beat their sales estimates, and all sectors’ revenues save Utilities grew in Q2.^[vii]

Widespread and fast revenue growth shows corporations’ underlying fundamental growth remains robust. The outlook is sunny, too. Analysts tracked by FactSet now pencil in Q3 earnings and revenue growth at 20.3% y/y and 7.7%, respectively.^[viii] Q4 earnings and revenue growth expectations are 17.6% y/y and 5.9%, respectively. And these likely underestimate growth since managements typically lowball their guidance to increase the likelihood they “beat” it later. Current Q3 and Q4 estimates are also significantly higher than expectations at the year’s start. Entering 2018, consensus estimates had Q3 year-over-year earnings and revenue growth at 15.2% and 5.8%, and Q4’s at 15.1% and 4.5%, respectively.^[ix] This suggests analysts already somewhat figured in tax cuts, but many short-changed the economy’s—and corporations’—revenue generating potential. Take 2019 projections with a few salt shakes at this point, but current estimates show 10.3% y/y earnings growth and 5.1% revenue growth.

Yet for all the hearty growth, sentiment towards corporate profits looks lackluster, which suggests plenty of room for the mood to brighten—and boost stocks further. Valuations, although never predictive, give a good gauge of sentiment. They suggest markets are far from frothy. The 12-month forward S&P 500 price-to-earnings (P/E) ratio is 16.6—just above the 5-year average—and is down from 18.5 in January.^[x]

One dominant media narrative, though, still holds stocks are a bubble waiting to pop. During the last bubble, sharply rising stocks—and rapid, large increases in valuations—helped illustrate the spreading euphoria. In late 1998—after the twin Asian and Russian debt crises—the S&P 500’s forward P/E fell to 17.5,^[xi] but then it surged almost 7 points in less than a year as the dot-com craze caught fire. It seems hard to argue this year’s P/E decline shows froth abounds. If an investor got out now, well ahead of any sign the economy or earnings are about to turn down—or of euphoria taking over—we suspect they could miss a great deal of bull market ahead.

Stocks show little evidence their march up the proverbial wall of worry is flagging. Key fundamentals like earnings look sound now and into the future, and we don’t see much on the horizon to credibly undermine that. While sentiment may be warming to this favorable outlook, it isn’t the irrationally wild optimism often seen at market tops, suggesting this bull has room to run.