The stock market closed at an all-time high on Monday. The S&P 500 (^GSPC) hit an intraday high of 2,143.16, before closing at 2,137.16. This is an incredible 220% gain since the market hit bottom on March 2009.
For the seven-year-old bull market to continue, experts broadly agree that we’ll need to see a pick-up in earnings growth, especially following five consecutive quarters of earnings decline.
“Earnings-driven bull markets seem to be the norm during the year following a profits recession trough,” RBA’s Rich Bernstein observed. “Typically, the market advances about 13-15% and multiples contract about 1-2 multiple points.”
Again, experts broadly agree that earnings growth will accelerate in the second half of 2016. But that’s when things get much more uncertain.
The most controversial number in the stock market.
What will earnings growth look like in 2017? According to FactSet, the consensus as of Friday was calling for around 13.5% year-over-year growth in S&P 500 earnings per share.
But in recent weeks, multiple Wall Street strategists, whose forecasts factor into this consensus estimate, have raised doubts about this lofty number. And so, the estimate for 2017 earnings growth has become the most controversial number in the stock market.
“We are in an odd position of thinking that this year’s numbers might be achievable but next year’s are likely way too high,” Morgan Stanley’s Adam Parker said on Monday.
“Don’t believe the hype: 2017 earnings growth likely to be closer to 5% and not 14%,” JPMorgan’s Dubravko Lakos-Bujas said in a recent note to clients. “For those placing faith in the grossly enthusiastic consensus EPS growth assumptions in the coming years, these hockey-stick projections will likely be revised down sharply.”
Lakos-Bujas skepticism toward the high growth assumption is supported by historical data.
“Over the last ten years, the consensus growth estimate for the following year was typically revised down by ~5%,” he observed. “Since consensus 2017 EPS growth of 14% is based on unrealistic assumptions of +7% sales growth (+5% ex-energy) and +50bp margin expansion, we expect an even sharper revision to next year’s EPS estimate (in the range of ~$10). We would expect a more realistic ~$125 EPS for 2017.”
RBC’s Jonathan Golub also made a similar observation about revisions, noting that even in the past five years, the trend has been for earnings forecasts to be revised down as the calendar progressed.
“Historically, annual estimates fall 1% from this point in the year,” Golub said in a recent note to clients.
Parker actually studied the history of earnings revisions since 1976 and found a very consistent pattern.
“Historically, bottom-up numbers start the year too high, averaging 14% growth in January of a given year, only to finish at 6%. In 34 of 40 years, bottom-up earnings estimates proved to be too high, and all six years they were too low were recession recoveries or the year after,” he said in a June note to clients.
“Given the growth and data backdrop, expectations appear far too high,” Barclays’ Keith Parker said on Thursday. “Downgrades to H2 and 2017 are likely to be a headwind, with negative corporate guidance an added risk as investors assess the fallout after the Leave vote.”
Not all strategists are just talking about the risks to earnings growth amid the uncertain economic backdrop. On Friday, Bank of America Merrill Lynch cut its forecasts, warning that S&P 500 earnings would grow by just 7% to $125 in 2017.
“We are lowering our 2016 and 2017 EPS forecasts to $118 and $124 from $124 and $133, respectively,” RBC’s Jonathan Golub said on Monday. “This implies EPS growth of -0.2% and 5.1%.”
Others already had more cautious growth forecasts.
“Modest profitability pressures are to be expected though more likely into 2017,” Citi’s Tobias Levkovich said. “Employment growth, wage increases and commodity price weakness are likely to impact corporate margins negatively, while fixed overhead cost under absorption in emerging economies can cut into profitability in an environment of limited pricing power.”
Levkovich estimates S&P earnings climb by 6% in 2017 to $130 from a $122.50 level this year.
We’re sure to get much more clarity in the next few weeks as big companies announce Q2 earnings and managements offer their outlooks for the rest of the year and beyond.
“Of far greater importance [than Q2 2016 earnings] is guidance, where confirmation of prospective growth in 2H2016 and 2017 could be well rewarded,” UBS’s Julian Emanuel said on Monday.