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Will Earnings Season Kill the Stock Market Rally?

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Now that the government has gone from shutdown to opened-up, and the Federal Reserve is standing pat as the economic fallout is assessed, investors’ nearest available worry is whether corporate earnings can support a stock market again trading at an all-time high.

While Corporate America is indeed struggling to produce bottom-line growth in a tepid economy, and several stalwart companies have delivered clanging earnings shortfalls this week, spongy profits are unlikely to be broadly poor enough to be the rally’s undoing.

Related: 3 Reasons to Love Stocks This Earnings Season

The concern about the earnings picture is familiar, and certainly understandable.

  • Profit growth has decelerated sharply in the past few quarters, up just in the low single-digits for Standard & Poor’s 500 Index companies.
  • Forecasts have come down sharply this year for 2013, but still appear aggressive for the fourth quarter and 2014, with growth among analysts expected to reaccelerate to above 10% next year.
  • Profit margins are already at historically high levels, and without strong revenue growth margins can only recede toward their long-term average.

Yet at the current phase of the bull market, it is common for earnings growth to flatten out – and, indeed, earnings growth has been weak all year without preventing stocks from rising more than 20%, as big macroeconomic risks have receded and investors took heart in a low-growth, high-liquidity environment.

As noted in the accompanying video discussion with Yahoo Finance’s Aaron Task and Lauren Lyster, S&P 500 earnings are up some 150% since the trough levels of 2009 – just about exactly the amount that the index itself has risen. Yet earnings and stock prices have not risen in lockstep the whole way. From 2010 through 2012, earnings grew significantly faster than stock prices climbed, compressing the price-to-earnings multiple on the broad market.

Related: There's A Decent Chance Stocks Will Crash: Henry Blodget

This year, the reverse has occurred, with the market gaining far more than profits have gone up, lifting the P/E in what’s commonly known as multiple expansion. This has happened as investors become more comfortable with the idea that the economic recovery has taken hold, and have moved money away from lower-yielding “safety” assets.

According to Goldman Sachs research, entering this earnings season, the S&P 500 was up 18%, with earnings up by only 5% and the other 13% the result of higher valuations on those earnings. Investors are, in effect, paying up now for the impressive profitability that has built up in recent years.

The notion that current 2014 forecasts look too high is both true and not necessarily alarming. Morgan Stanley calculates that since 1976, the average year-ahead profit-growth consensus was 14%, which on average got revised down to the 5% long-term historical profit-growth rate.

This is how over-optimistic analysts do business, and the market tends not to be shaken by this process absent an outright recession or macro shock. This quarter in particular, expectations have been guided quite a bit lower and most companies face relatively easy comparisons with year-ago results.

Sure, much of the earnings growth is the result of stock buybacks pushing up reported per-share profits, and ultimately multiples will get stretched to a point that stocks will become quite risky and vulnerable to any whiff of an economic slowdown or tighter money.

Yet this P/E expansion pattern has plenty of precedent. Tony Dwyer, strategist at Canaccord Genuity, points out that the market is neatly tracking the past two times we saw valuation-expansion phases absent a recession, from December 1994-August 1997, and before that from July 1984 to August 1987.

By this rough analogy, we are approximately halfway through this process – though of course there is no guarantee that stocks will ultimately get as expensive and dicey as they did those two times. If stocks continue to feed off of an accommodative Fed trying to prod a sluggish economy to life, while the corporate sector outperforms the household experience, then we might indeed end up in a bubbly place. But it’s hard to make the case yet that we’ve arrived there.

Another element of the current reporting season is that global-growth proxies such as industrial stocks are projected to show better growth than the domestic/consumer-related sectors for the first time in more than two years, says Barclays Capital. The upbeat response today to General Electric’s (GE) decent report, including a strong industrial order backlog, shows that this could be a bright spot after many heavy-industrial stocks suffered amid the China-slowdown obsession around midyear.

None of this means investors will be insulated from sharp retrenchments or blow-ups in individual stocks. Late in a profit cycle, some companies run out of fuel to drive growth, as International Business Machines (IBM) showed with a lousy quarter and savage punishment of its stock. Goldman Sachs (GS) had to resort to severe cost-cutting to make a decent EPS number given soft trading revenue.

Yet reliable growers are only being more lavishly rewarded given the hit-or-miss nature of profits by sector. And so we see the likes of Google Inc. (GOOG) surmounting both $1,000 a share and $300 billion in market value with impressive results that show it feasting on surging mobile-ad volumes.

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