Earnings Take Center Stage

7/24/2017


Since closing at all-time highs on July 14, the Dow Industrials and Dow Transports have moved mostly sideways into earnings-reporting season. But the S&P 500 Index and Nasdaq Composite, helped by the resurgent technology sector, have reached fresh all-time highs. With the Dow Theory squarely in the bullish camp, a nearly fully invested posture remains appropriate. Our buy lists have more than 94% in stocks.

Encouraging estimate trends

Early reports for the June quarter have been mostly positive, with a higher-than-normal proportion of companies exceeding analyst profit targets. Consensus estimates now call for a 6.8% year-to-year increase in per-share earnings for the S&P 500 Index, with nine of 11 sectors reporting growth, according to FactSet. Sales are expected to climb 4.8%, with only the telecom sector expected to report a decline.

Profit-estimate trends heading into the quarter were encouraging, and guidance has been mostly positive among early reporters. Since May, estimates outside the energy sector have held roughly steady, defying the erosion typically seen heading into June-quarter results. According to researchers at BlackRock, the ratio of analysts revising their global earnings estimates higher rather than lower recently jumped to its highest level in about five years.

Profit-estimate trends for smaller companies lag, partly because bigger companies stand to benefit more from the slumping dollar. Still, consensus profit estimates for the year ahead reached fresh highs this month for the S&P 500, S&P MidCap 400, and S&P SmallCap 600 indexes. 

Unfortunately, forward price/earnings ratios for all three indexes are also near fresh highs for this bull market. The median stock in the S&P 1500, which includes stocks from all three indexes, trades at 19.6 times expected current-year earnings — about 15% above the norm since 2004, and only slightly below the maximum of 20.2.

With valuations expensive and enthusiasm heading into earnings season relatively high, the potential for near-term disappointment should not be underestimated. The S&P 500 Index has not suffered a peak-to-trough drop of even 3% so far in 2017, so investors' reaction to a more substantial correction is tough to predict.

Conclusion

As always, the market's reaction to quarterly reports will reveal whether results have exceeded expectations. While a near-term pullback is possible, we're inclined to view any such decline as a correction in an ongoing bull market.


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