No amount of uncertainty and bad news seems to be able to keep the financial markets down for long.
On Friday, stock markets rallied again, sending the S&P 500 (^GSPC) up 17 points to close the third quarter at 2,168. The S&P continues to be within striking distance of its Aug. 23 all-time high of 2,193.
Surprisingly, this market strength comes as expectations for earnings growth have persistently disappointed for years. Because earnings are the most important driver of stock prices, this has left many investors lost and confused.
Many analysts attribute some of the counterintuitive trend to low inflation and depressed interest rates. But most analysts warn that it nevertheless has made for stretched valuations, which makes the market more vulnerable to a volatile sell-off.
Valuations are stretched
“As has been highlighted often of late, almost any way that you look at it, stock market valuations [as measured by the price-to-earnings ratio] are at elevated levels based on their history,” Gluskin Sheff’s David Rosenberg noted on Friday. “We currently have a market in which the cost to buy one dollar of future earnings is historically elevated.”
Currently, the forward 12-month P/E ratio, which is based on forecasts for earnings growth in the next 12 months, is high at around 16.6. This is far above the 5-year average over 14.8 and the 10-year average of 14.3.
There are a couple of ways for valuations revert back to more modest levels including falling stock prices or surging earnings.
Earnings season will be telling
Currently, analysts have high hopes for earnings growth to come roaring back in the fourth quarter of this year and all of 2017.
“We believe this earnings season is important to the near-term future of the bull market,” Schwab’s Liz Ann Sonders, Brad Sorenson and Jeffrey Kleintop said on Friday. “With valuations at least modestly elevated by most measures, earnings need to start to carry the weight if this bull market is to advance.”
In a few weeks, earnings season kicks off. In addition to reporting earnings for the three months ending in September, companies will also share what they expect for the remainder of the year as well as next year. Currently, the consensus expects S&P 500 earnings to surge 13%-14% in 2017.
“Taken in context with a 3Q Earnings Reporting season which begins on October 10th (the day after the next Clinton vs. Trump debate) that is likely to feature corporate commentary guiding down bottoms-up consensus’ ‘irrationally exuberant’ 13.8% growth forecast for 2017 (UBSe 5.9%), stocks look poised to remain volatile into, and perhaps beyond, the November 8th Election,” Emanuel said on Friday.
It’s worth noting that earnings haven’t been just lackluster; they’ve been negative.
“For Q3 2016, the estimated earnings decline for the S&P 500 is -2.1%,” FactSet’s John Butters said on Friday. “If the index reports a decline in earnings for Q3, it will mark the first time the index has recorded six consecutive quarters of year-over- year declines in earnings since FactSet began tracking the data in Q3 2008.”
In summary: Stock prices are near record highs despite months of declining earnings, which has stretched valuations to worrisome levels. Meanwhile, almost all analysts argue the market needs robust earnings growth for the rally to continue. But some analysts warn that the consensus estimate for earnings growth is far too optimistic. And so, you can begin to see why the stock market is in a precarious position.
Sam Ro is managing editor at Yahoo Finance.