Weekly Market Outlook

Earnings Miracle Needed to Get S&P 500 Values Out of Clouds

The Federal Reserve is looking for any excuse to raise interest rates, global growth is slowing, and yet stock analysts are predicting the fastest earnings expansion since the bull market began. They better be right.

Hitting forecasts for next year would require S&P 500 Index companies to increase profits by 13 percent, something that hasn’t happened since 2011. Failing to do so would risk inflating equity valuations that at 20 times annual income are already the highest since the financial crisis.

While the confidence of analysts helps explain the stock market’s resilience, such profit growth is lately the one thing investors have been conditioned not to expect. They’ve just endured a five-quarter stretch where every prediction for higher earnings fell apart just as reporting season arrived.

“You’d have to have a lot of things working in unison to achieve that number, a lot of things would have to go correctly,” Peter Andersen, chief investment officer at Fiduciary Trust Co. in Boston, said by phone. His firm manages more than $11 billion. “You’ll have areas where growth will be quite strong, like certain technology areas, but other industries like financials will never have that kind of growth through 2017.”

While the U.S. equity market has sidestepped threats in the past ranging from Europe’s sovereign-debt crisis to the prospect of a government shutdown, it’s had much less success thriving in the absence of expanding earnings. Through 2014, both the price of the S&P 500 and the annual income of its members posted six consecutive years without a decline — but that ended in 2015, when the index slipped 0.7 percent and profits dropped 3.1 percent. Futures on the gauge gained 0.5 percent at 9:38 a.m. in London.

The trend has worsened in 2016, with annual income earned by companies in the S&P 500 falling to $106 a share last quarter from a high of $113 in September 2014. Quarterly profits in the S&P 500 are headed for a sixth straight decline in the third quarter, matching the longest earnings recession on record, according to data compiled by Bloomberg.

Wall Street analysts have continued to push back the turning point. A survey of estimates as recently as July pointed to S&P 500 companies returning to profit growth in the third quarter of this year. Those same analysts now see a decline of 1.4 percent.

Hope springs eternal for the fourth quarter and analysts still predict annual income will increase 10 percent from now to $117 per share by the end of 2016. The projected expansion for the next 12 months is even loftier: to get to $124 a share at this point next year, profits would have to expand another 16 percent, a rate of growth that is twice the historical average.

To investors like AllianceBernstein LP’s Jim Tierney, it’s all a bit much to swallow.

“I think that number in reality will turn out to be a little bit aggressive,” Tierney, the New York-based chief investment officer of U.S. concentrated growth portfolios at AllianceBernstein, said by phone.

With the gap between current and future earnings so stark, valuing stocks becomes even more subjective than it normally is. If expectations are reached and earnings indeed make it to $124 a share in the next 12 months, forward-looking price multiples put the S&P 500 at 18.3 per share, much closer to its historical average.

While faltering earnings might bode poorly for future gains, U.S. stocks have proven resistant to protracted declines. One valuation case that favors equities is the bond market comparison known as the Fed model. Going by that, which plots per-share income against fixed-income yields, the S&P 500 is currently cheaper than it has been 70 percent of the time since 2000.

What could spur the earnings growth? For one, oil prices could stop falling. The bane of earnings growth since falling 60 percent, crude is faltering again after almost doubling in the first half of the year. If not for energy companies, S&P 500 profits would be up 1.6 percent in the third quarter, the analyst estimates show.

Softness in the U.S. dollar would also help by making overseas earnings more valuable. A Bloomberg index tracking the value of the U.S. currency versus international counterparts is flat since March.

“Just having the dollar and oil stay where they are will get you there,” said David Kelly, chief global strategist at JPMorgan Asset Management in New York.

Leaving aside the dollar and oil, future profits will be decided by the strength of the U.S. economy, Kelly said. That notion may not assure every investor, as sluggish economic numbers in the U.S. continue to keep the Fed’s plans to hike interest rates at bay.

Economic data in the U.S. has been missing expectations this month, as a Bloomberg index of economic surprises turned negative for the first time since July. The gauge reached the highest since 2014 on Aug. 5, before touching a two-month low last week.

Yearly growth in the U.S. has declined for five straight quarters in the U.S., with second-quarter GDP at 1.2 percent the lowest in three years. Global growth remains muted, the International Monetary Fund said in a July report when it cut expectations for 2017 growth to 3.4 percent in the wake of the Brexit vote.

“We’ve been set up with unrealistically high growth expectations and valuations which are pretty high,” Ben Laidler, global equity strategist at HSBC Securities USA Inc. in New York, said in an interview on Bloomberg Television Thursday. “We have 14 percent earnings growth expectations for next year for the world and you’ve never even seen close to that with the GDP outlook we have.”