Earnings Not Sole Driver Of Stock ETFs Rally

The stock market may be rip-roaring higher, but earnings aren't keeping pace. That's according to a new report from FactSet indicating corporate profit growth hit a road bump during the latest quarter. Yet equity ETFs are soaring.

Aggregate earnings for S&P 500 companies may only increase by 2.1% in Q3, the slowest rate of the year. That follows growth of 13.9% in Q1 and 10.3% in Q2.

The third-quarter figure is an estimate and may be revised higher if companies beat analyst expectations, as they usually do. The third-quarter earnings reporting season began in earnest last Thursday and will continue for the next several weeks.

Hurricane Factor

The biggest culprit for the earnings slowdown may be hurricanes, which more than a dozen firms have already blamed for hurting profits. The second-most-cited excuse was foreign exchange rates, says FactSet.

As in any quarter, profit growth during Q3 isn't expected to be even across sectors. Energy may see the fastest growth at nearly 114% thanks to a rebound in oil, natural gas and refining markets from depressed levels.

That's followed by the technology sector, with growth of 8.8%, a number boosted by strong performance in semiconductor companies in general and Micron Technology in particular. Next is retail, with forecasted growth of 6.3%; materials with 2.8%; industrials with 2.2%; health care with 2.2%; and consumer staples with 1.6%.

On the flip side, the biggest earnings losers during Q3 are the financial and the consumer discretionary sectors, with expected declines of 11.4% and 2.9%, respectively. Utilities and telecom are expected to see earnings declines of 2.6% and 1.4%, respectively.

Source: FactSet

Q4 Earnings Rebound

At first glance, it's hard to reconcile the tepid earnings growth of Q3 with this year’s sizzling stock market rally. The S&P 500 has returned 16% year-to-date, with all-time highs reached on a near daily-basis in October.

But a closer look at the FactSet data reveals Q3's slowdown is more of a temporary setback than the start of a more bearish trend.

As it stands now, analysts expect that, in the fourth quarter, earnings will reaccelerate to double-digit levels, with earnings growth of 11.1% expected for the S&P 500 as a whole. Moreover, if analysts are correct, each of the 11 sectors may register growth in Q4.

Correlation Between Earnings & Returns

If growth rebounds during the final quarter of the year, that will go a long way toward boosting the earnings figures for 2017 as a whole. The estimated growth for S&P 500 earnings for 2017 as a whole―9.1%―helps explain a lot of this year's market rally, though not all of it.
 

Source: FactSet

There is some correlation between sector earnings growth for 2017 and sector performance for the year.

For example, telecom is the only sector for which earnings are anticipated to decline this year, and it's also only one of two sectors that is in the red year-to-date. The $1.4 billion Vanguard Telecommunication Services ETF (VOX), the largest ETF tracking the sector, is down 6.5% on the year.

Similarly, materials and technology—two of the three sectors with faster earnings growth than the S&P 500—are two of the three top-performing sectors of the year.

Of course, the correlation between 2017 earnings and performance isn't rock solid. Energy, for instance, has the fastest earnings growth this year and the worst performance. At the same time, health care has middle-of-the-road earnings growth, yet is the second-best-performing sector.

Valuations Climbing

While there may be deviations between earnings and performance in the short term, over longer periods of time, there is a tight link between the two.

That's why some investors are puzzled by the recent surge in the stock market. Clearly, the S&P 500 is climbing much faster than earnings, rising 16% already this year (14.4% excluding dividends) versus expected earnings growth of 9.1%. That's on top of the 12% return in 2016, a year that had virtually no earnings growth.

In other words, the amount of money investors are willing to pay for each dollar of corporate earnings is rising. In market jargon, it's called "multiple expansion."

As FactSet reports, the forward price-to-earnings ratio for the S&P 500 eclipsed 18 for the first time in 15 years this month.

Goldman Sachs said this week the S&P 500 is trading in the 89th percentile of historical valuations.

Explanations

There are a few explanations for why earnings multiples may be expanding. One is that the bull market is late in the cycle, so multiples naturally increase as the economy hums along, unemployment drops to exceptionally low levels and confidence (and euphoria) grow.

Another explanation is that interest rates are low, so future earnings are worth more when discounted back to the present. Sure, interest rates have been low for many years now, ever since the financial crisis of 2008, but it's a completely different thing to be low immediately after a crisis compared to 10 years after the fact.

It may be that the realization that low rates are here to stay is finally making its way into stock market valuations.

Last but not least, tax reform is another factor that may be enhancing valuations. If corporate taxes are cut, profits in 2018 and beyond are likely to jump. It only makes sense that markets would price that increase in ahead of time. A CNBC survey of analysts suggests that tax cuts could boost S&P 500 earnings next year 7-12%.

 Contact Sumit Roy at [email protected]