Much of the stock market’s strength this year seems fueled by strong corporate earnings growth, analysts argue. First quarter earnings jumped 15% year-over-year, which was the the best showing in five years.
But Bank of America analysts are reflecting on those results with some concern.
In a research note titled “As good as it gets,” analyst Savita Subramanian notes that she expects second quarter earnings growth to slow to 9%. The Wall Street consensus is even more modest, anticipating 6% growth.
Subramanian’s peers warn this could be a problem for stocks.
“Earnings growth may have peaked for the cycle,” according to BofA fixed income analyst Martin Mauro. “Although expectations are for S&P earnings growth to easily surpass the rate of US economic growth, our forecast for Q2 EPS growth of 9% may not be welcome news to the market, since it would represent a deceleration from Q1’s 13% level.”
All of this comes as the Federal Reserve is tightening monetary policy, which analyst argue is bearish for stocks.
“And while stocks still look inexpensive relative to bonds, if the Fed follows through with further rate increases, that situation could reverse,” he added.
Meanwhile, Washington is another wild card, according to Mauro.
“The equity market expects some measure of tax reform or infrastructure spending,” he said. “If no signs of that appear later this year, we think stocks may suffer.”
The market is vulnerable
Estimates for next quarter have already come down 2% over the course of first quarter earnings season, according to Subramanian, already reflecting some subdued enthusiasm.
Subramanian added a warning that “crowded stocks” where there is a lot of interest are susceptible in periods of de-risking and rebalancing. This is particularly a risk for tech stocks.
Meanwhile, high expectations for these widely-held stocks could present risks during second quarter earnings season. Bank of America explained that the most overweight stocks tend to sell off more on negative results than less widely-held stocks. According to their research, companies with more than a 50% overweight in active managers’ holdings that missed on both EPS and sales in the first quarter underperformed by 0.7 percentage points more over the next five days than other stocks that missed.
Continued earnings growth is important, particularly at the market’s current elevated valuation.
As RBC’s Jonathan Golub explained, valuation for the S&P as measured by the price/earnings (P/E) multiple currently stands at 17x, which is above average.
But it’s not all bad news.
Golub notes that the current pace of earnings growth helps support that valuation.
“We have to differentiate between economic growth and earnings growth, and right now, earnings growth is pretty strong,” according to Golub.
Furthermore, he explains that it’s not unusual for P/E multiples to continue expanding in the later part of cycles.
Another positive regarding earnings: Even though 2017 earnings estimates are about 0.9% lower relative to where they stood at the beginning of the year, that marks the smallest downward revision since 2009.
In other words, analysts’ forecasts of earnings are not deteriorating like they usually do.
Nicole Sinclair is markets correspondent for Yahoo Finance.
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