S&P 500 Q3 Earnings Season Was Deceptively Decent
Third-quarter earnings season is pretty much done and, by and large, companies on the S&P 500 did better than expected. This means either they really did do well or expectations were pretty low.
To date, 85% of S&P 500 companies have reported their financial results. The blended revenue growth rate for the third quarter was 2.6%. If the S&P 500 reports growth in third-quarter sales, it will be the first time the index has reported year-over-year revenue growth since the fourth quarter of 2014. (Source: “Earnings Insight,” FactSet, November 4, 2016.)
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As for actually making money, the blended earnings growth rate is 2.7%. If the S&P 500 reports growth of any size, it will be the first time it has done so since the first quarter of 2015. This means the S&P 500 has ended the longest earnings recession on record. This is quite the turnaround. On September 30, the estimated third earnings decline for the S&P 500 was -2.2%.
So all good! The S&P 500 is back on track! Not quite. Just as analysts would say one quarter of earnings decline is not bad news for the economy, it’s fair to say that one quarter of earnings growth out of eight does not mean the S&P 500 is healed.
Au contraire. It’s going to take more than one measly quarter of marginal earnings growth to save the S&P 500. Even with the third-quarter earnings growth and unbridled optimism about the fourth quarter, the S&P 500 is still on track in 2016 for a fifth straight year of year-over-year declines in operating earnings.
This means that either stocks are underperforming or analysts are overenthusiastic. No matter how you look at the S&P 500, it’s in nosebleed territory. And if history is any indicator, it is poised for a 50% correction.
And 2017 will be a record sixth year of declines in year-over-year operating earnings declines. That’s an easy call to make. The earnings predictions for 2017 started at above $140.00. That’s going to be a tough target to hit, given the slow pace of U.S. economic growth. It might explain why 2017 earnings projections have since fallen to around $132.00.
S&P 500 Poised for 50% or 69% Correction
Because of artificially low interest rates, investors have nowhere else to park their money but the stock market. This has sent equities to dizzying heights. Even in the face of weak economic growth, an earnings recession, record share buybacks, and barely-there revenue growth, the S&P 500 continues to climb higher and higher.
While the S&P 500 has been on a roller coaster ride in 2016, it has been bullish since Donald Trump won the U.S. election. On Thursday, the S&P 500 was, along with the NASDAQ, closing in on its record high.
Stocks got an unnecessary boost after Federal Reserve Chair Janet Yellen signaled that the central bank was on track to raise interest rates when it next meets in December. Well, she wasn’t that clear about it; she said interest rates, “could well become appropriate relatively soon.”
This will continue to thrust the S&P 500 into nosebleed territory, which is totally unjustified. For years, investors have been rewarding companies on the S&P 500 for either not losing or making as much money as they thought they would. Basically, investors have been rewarding companies for their effort.
How far could the S&P 500 crash? According to the Case Shiller cyclically adjusted P/E (CAPE) ratio, the S&P 500 is overvalued by 69%. The ratio is currently at 27.05. The average is 16. (Source: “Online Data Robert Shiller,” Yale University Department of Economics, last accessed November 17, 2016.)
There are two ways that investors look at that number. For every $1.00 in earnings, an investor is willing to pay $27.05. Or, it will take 27 years for the earnings of the average stock on the S&P 500 to equal its price.
The ratio has only been higher three times: in 1929, 1999, and 2007. Each time, it was followed by a crash in excess of 50%. Most recently, in 1999, the crash came when the S&P 500 tumbled around 50% and in 2007, it was when the S&P 500 plunged 55%.
The S&P 500 is currently near 2,185. A 50% correction would erase five years of growth and take the index to the 1,100 level, which also happens to be a tested support level. A 69% stock market crash would take the S&P 500 back to where it was when it bottomed in March 2009.
What factors could precipitate that kind of stock market crash? The global markets didn’t respond very well to the Fed’s premature rate hike last December. Who knows how the global markets will respond to the early days of the Trump presidency?
And who knows how investors will react when valuations and fundamentals run in step? Companies can only manipulate their financials with share buybacks and cost-cutting measures for so long. Eventually, earnings will have to matter. Right now, the valuations are entirely unsustainable.
