Stock Market Comment: Should we be worried about S&P 500 amid declining earnings?

• S&P 500 kept ignoring weakening earnings forecasts throughout the year

• US equities look more expensive than they were in 2007

• Not every earnings recession is followed by GDP contraction

• Sentiment may dominate over fundamentals this year

• S&P 500 breaches above 3300 pts

Major US banks launched Wall Street earnings season for Q4 2019 this week. It is expected that US companies will show another contraction in headline EPS. In this commentary we will take a look at how earnings estimates for S&P 500 changed over the year and whether we should be worried about S&P 500 amid declining profits of companies.

S&P 500 ignores falling earnings estimates

It is often said that the US stock market behaved irrationally throughout 2019 as investors looked past deterioration data and kept pushing equities higher. Of course, there were reasons to cheer as the United States and China reached some sort of an agreement on trade and Fed started to expand its balance sheet. However, it does not change the fact that we have some trade barriers in place that were non-existent a year ago and signing of ‘Phase One’ deal did little to change it. We have elaborated on the topic in our “Macroeconomic update” released on Monday, January 13. The irrationality of S&P 500 in 2019 can be best described by the chart below where index performance is compared to estimated EPS from continued operations. Such a strong correlation would hint at quite an efficient market but in this case earnings are presented on an inverted axis meaning that S&P 500 grew when earnings estimates declined.

S&P 500 kept rising throughout 2019 in spite of declining earnings estimates for the year. EPS from continued operations (white line) is presented on an inverted axis. Source: Bloomberg

US equities look more expensive than in 2007

Taking a look at our chart comparing historical valuations of S&P 500 index in regards to forward earnings, one can see that companies from the index have not been that expensive since April 2018 as they trade at 85 percentile of historical P/E values now. An interesting point to note is that at the stock market peak preceding the Global Financial Crisis, S&P 500 companies were cheaper as they traded at 65 percentile. Should S&P 500 be priced in-line with 2007 valuation, the index would sit at around 2880 pts - 12.7% lower than today. However, it should also be noted that companies’ earnings are less expensive than they were at the turn of millenia when the stock market was going through a dot-com bubble.

S&P 500 companies have not been that expensive in terms of forward earnings since April 2018. Moreover, they are much more expensive than they were ahead of the GFC. Green and red lines show percentile values of historical forward P/E multiplied by 12-month forward EPS for the month. Source: Macrobond, XTB Research

Does earnings recession mean that economic recession is ahead?

While stocks tend to decline during GDP recession, correlation with earnings recessions is not so obvious. But does earnings recession mean that economic recession is ahead? This is the key question for now and the answer is - not necessarily. Poor performance of companies should translate into poor performance of the whole economy but it is not always the case. Out of all earnings recession in the post-WWII period about three-fourths were followed by economic recession. The latest S&P 500 earnings recession took place between Q4 2015 and Q3 2016 when corporate profits failed to grow amid disappointing performance of the industrial sector. However, the mid-decade plunge in earnings was not followed by the GDP recession. In fact, S&P 500 companies experienced three earnings recessions since the turn of the millenia and only 1 was followed by GDP recession (2008-2009). 

While a significant correlation can be spotted between growth in S&P 500 earnings and US GDP growth, out of 3 earnings recession in the previous 20 years only 1 was followed by the US GDP contraction. In contrast to headline EPS, EPS from continued operations continues to enjoy positive but slowing growth. Source: Bloomberg, XTB Research

Forget about fundamentals… its election year!

There are some factors that one could be worried about when it comes to the US economy and the US stock market. However, there is also a strong case against any major plunge in the stock markets this year - 2020 is election year! In our last week’s Stock Market Comment we showed that the US stock market tends to rise during years that host US presidential election. To some extent it can be ascribed to promises made by candidates. We got a glimpse of it yesterday when Larry Kudlow said that another tax reform, including tax cuts, will be unveiled during Trump’s presidential campaign. Apart from that, ‘Phase 2’ trade talks will be underway this year so traders should expect politicians to keep boosting moods as they did during ‘Phase One’ talks. A key takeaway is that markets look to be driven more by sentiment rather than fundamentals today and traders should keep it in mind, especially during election year.

S&P 500 (US500) does not seem to be concerned at all by weaker earnings. The index continues to push higher and has breached 3300 pts handle for the first time today. The near-term support can be found at 3230 pts - the lower limit of 1:1 structure and lower limit of the upward channel. The topside resistance of the channel runs at around 3330 pts now, so the index still has some room to grow. Source: xStation5