Margins of 10.31% Reach A Record High

No Blow Off Top

It's impossible to predict a trend which is based on irrational buying. Some bears think that the rally this year is irrational, but I would argue that it isn’t because the central banks are adding liquidity at a record pace and earnings are reaching record highs. The labor market can’t get much better and business optimism is high. Finally, inflation has lowered. This makes it tough for the Fed to make its argument that it should be raising rates, hurting its credibility. However, stock valuations increase because low inflation means future earnings are worth more.

The chart below gives you a visualization of where the market is with returns in terms of figuring out how close we are to a blow off top. It shows the distribution of S&P 500 rolling 5-year returns from December 1930 until July 2017. The median bull market peak has a 21.4% annual return; the current annualized return is 14.8%. Most bull markets peak with higher returns which is the basis for the bearish argument that stocks will increase at an accelerated clip. Weirdly, I’m disagreeing with the bears by making their own argument. Stocks started this bull market at higher than median valuations, so returns probably won’t reach levels normally associated with a top. In terms of valuations, they’re already higher than most bull market tops. Therefore, I don’t see a blow off top coming. If one did occur, it would make me incredibly bearish as multiples would approach the 2000 tech bubble high.

Trump Isn’t Important

In the beginning of the quarter FactSet put out the data on the number of times corporations mentioned Trump in their earnings calls. The number was low, but it was too early to tell if it was a trend. It turns out the decline was significant as with 75% of firms reporting earnings, the number of firms mentioning Trump fell to 44 which was down from 181 in Q4 2016. With the Congress not getting much done on healthcare or taxes, firms have moved on to focusing on their own businesses. This is good; the worst possibility would be if firms decided to put new projects on hold until something was passed. Waiting for Congress to pass something isn’t a great idea.

The chart below gives you the specific break down of the policies discussed on conference calls. The issue we’re focused on is tax policy which doesn’t look as likely to get changed as it did in Q4. On the bright side, trade policy was worried to be a negative as some thought protectionism was creeping up. However, global trade has increased this year which is partially the reason why emerging markets have had such a great year (up over 25% year to date). With regulations, Trump is rolling back net neutrality. On the other side, Europe is increasing internet regulations as they just levied a massive a $2.7 billion fine on Google, making this a wash.

Earnings Update

Let’s look at the updated earnings results as last week was the last major week for earnings season as the results slow to a trickle this week. Snap’s earnings will be the report I’m focused on this week (Thursday). Last week the big story was the sales growth beats which were spurred partially because of the weak dollar. This weak it was more about margin improvements. Profit margins were expected to be 10.18% last quarter and now they’re expected to be 10.31%. With most of the firms reporting earnings, that number is close to the final result. That makes me bearish on future results because I think we’re close to the ceiling in margins.

As I just mentioned, the tailwind of the weakening dollar is coming just in time to support sales growth. The percentage of firms beating sales growth according to S&P Dow Jones was 68.3%. That’s with 419 firms reporting earnings. With 422 firms reporting earnings, 70.14% beat profit estimates which is the 5thbest quarter since Q2 2013. To summarize this week, there was some moderate weakness spurred by sales growth falling below the recent pace. It was on a record pace, so don’t think of this as a negative.

The chart below shows the expected year over year earnings growth rate in Q2. As you can see, before the quarter started growth was expected to be 6.3%, but now it’s expected to be 10.1%. The results have supported the stock market during the political turmoil when it comes to getting tax reform done. The results were even better on an as reported basis as the growth was 20.4% year over year.

According to S&P Dow Jones, the as reported earnings growth is expected to be 23.1% in Q3. The FactSet numbers are dramatically different as the growth rate is expected to fall from 10.1% to 5.6%. The chart below shows the change in Q3 earnings estimates in the past few weeks. As you can see, the estimates are down huge despite the beats this quarter. I think the reason for the difference in growth rates between Dow Jones and FactSet is because FactSet doesn’t include the earnings of firms which lose money. There were a lot of firms losing money in 2015-2016 during the earnings recession. That makes the comparisons easier for the Dow Jones numbers than the FactSet numbers. For Dow Jones, the tough comparisons come in Q4 2017 and Q1 2018.

Conclusion

Year over year earnings growth spiked higher in Q1 and Q2 as comparisons were easy. They will begin to get tougher in the next few quarters as margins reach their ceiling. The tailwind, which I think is keeping stocks up, is the declining dollar. That will help sales growth for multinationals. If the economy strengthens, that could ironically be bad for S&P 500 earnings as it would cause oil to go down and stymie the recent multinational sales growth caused by the weak dollar.