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Why the Poor Response to Good Earnings?

May 8, 2018, 10:07 am

May began with stocks little changed from where they started in April despite a strong earnings season. S&P 500 earnings are expected to increase a spectacular 23% in the quarter aided by lower corporate tax rates, but it and the other major indices are well below their best levels of the year.

Why the poor response to earnings?

For one, earnings growth was already partially priced in by Wall Street since the new tax law passed last year. Two, interest rates have been on the rise and will likely continue to increase as long as the U.S. economy remains healthy. While the 10-year Treasury yield seems to stall out whenever it hits 3% (it started the year at 2.4%), there has been a much bigger increase in corporate yields.

The lowest investment grade debt, BBB bonds, now yield 4.3% after beginning the year around 3.45%. Bond yields are much more competitive than stock yields since the start of the financial crisis. Plus, the widening of the credit spreads make some analysts concerned that economic growth is peaking and that a recession is in the cards.

The good news, however, is that stocks remain cheaper than they have been for a while. The S&P is now trading at 16.8X 2018 EPS estimates of $158. The inverse of the PE gives us an earnings yield of close to 6%, which is still better than the higher bond yields.

Given this, I think stocks can still regain the lost ground and end 2018 on a high note as long as earnings continue to grow, even if it’s at a slower rate. If by year-end current estimates for S&P earnings of $172 stay in place, the index could easily close 2018 at 2,900, which is roughly 17X the 2019 EPS estimate – a 9.4% gain.

In the meantime, as long as interest rates don’t go too much higher we may see stocks drift a bit through the summer as investors are comfortable with the 2019 EPS estimates. It’s important to stay cautious during this period and continue to focus on stocks trading at reasonable valuations with strong company-specific catalysts to drive them higher over time, as this should position you for solid profits when the market begins to fire on all cylinders again.

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