INSIGHTS

On August 08, 2016

AAM Viewpoints - Are Earnings Bottoming?

We made it through the craziness of the conventions and now it is up to the Olympics to captivate our attention, and hopefully distract us from the elections, at least for the next two weeks. When it comes to success in the Olympics there is sometimes the specter of athletes using doping to produce superior results, and as the U.S. equity markets are once again hitting all-time highs there is talk of its own version of doping, monetary policy, being the driving force. Clearly, many were surprised when the global equity markets began a strong rally following the two-day Brexit selloff, but we believe it is primarily an improving corporate earnings outlook that is driving the gains not just hopes of more post Brexit easing. However, moving forward we believe it will need to be the actual gains in corporate earnings that allow us to continue hitting new all-time highs and sustain this current equity bull market into 2017.

A year ago the expectations were for S&P 500 earnings to grow 8.72% on a year-over-year basis. That ticked up to 9.39% six months ago, and then 12.58% three months ago and has now jumped to 16.97%. Not only is this level up significantly from a year ago but it is also accelerating which we, and apparently the markets, view very favorably. This, combined with a much-better-than-expected 2^nd quarter earnings season is, we believe, driving the U.S. equity markets to new all-time high levels. Specifically, with 80% of the S&P 500 companies having reported 2^nd quarter earnings, we show 78% are running ahead of expectations compared with 74% last quarter. We have also seen median revenue growth tick up to 2% from 1%. In the end, we think this quarter will end up with the best level of earnings surprise in almost two years, which was about when we entered this current earnings recession which has seen earnings growth decelerating for eight quarters and go negative for the last five. Though we still have about 20% of the earnings to be reported this quarter, it looks like it will be statistically a significant move up from the last five quarters and we believe a good sign that we have finally turned the earnings corner.

From our perch, U.S. equity markets are a bit stretched when we look at valuations and this is why we would like to see a modest short-term correction in the near term. Specifically, the current trailing P/E (Price-to-Earnings Ratio) for the S&P 500 sits at 20.47, its highest level since late 2009 and well above its 10-year average of 16.74. Looking at P/B (Price-to-Book ratio) and P/S (Price-to-Sales Ratio) tells a similar story, however, if we look at dividends we get a slightly different theme. The S&P 500’s current dividend yield of 2.10% is slightly above its 10-year average of 2.08% and its spread to the U.S. 10-year Treasury note is currently +53 basis points with a 10-year average of -82 basis points. Thus, based on yield, U.S. stocks look attractively priced and we might add that the dividends for the S&P 500 have grown 6.87% year-over-year (45-year average is 6.38%).

As mentioned above, we would like to see a gentle near-term pullback in equities or at least a consolidation. The cause might be stretched valuations, the upcoming election, the Zika virus, falling oil prices, overreaction to one data point (think May 2016’s Job’s report) or a multitude of other factors. However, we would use the opportunity to add to the markets and rebalance to attractive pockets. Currently we would favor adjusting allocations up in growth, small-cap and international stocks. For the second half of the year we should experience more humble returns than occurred in the first half but we continue to believe the equity bull market will remain intact into 2017.

CRN: 2016-0808-5500 R

Past performance is not indicative of future results. This commentary is for informational purposes only. All investments are subject to risk and past performance is no guarantee of future results. Please see the Disclosures webpage for additional risk information. For additional commentary or financial resources, please visit www.aamlive.com.