Home / Opinion / What earnings giveth to stocks they can taketh away

New York: The market’s worst defence could be its too-good offence.

The stock market plunged on Monday, extending a slide that started last week. The Dow Jones Industrial Average sank as much as 1,500 points before recovering to close just down 1,175. The S&P 500 Index dropped more than 4%. This, of course, wasn’t what was supposed to happen for a specific reason: earnings. Much of what has been driving stocks to new highs regularly in the past year has been corporate profits, which have been rising consistently, often faster than expected. In fact, the regular retort to those who credited President Trump’s tax cuts as the sole reason for the market’s rise was essentially “It’s the earnings, stupid."

Profits for the S&P 500 are expected to have risen 13% last year. Companies in the fourth quarter have not just been beating earnings expectations, but about 80% of the companies in the S&P 500 have been reporting better-than-expected sales, which is more than any time in the past five years. That’s something that is incredibly difficult to do if the economy is not reasonably healthy. What’s more, analysts now expect those strong earnings to continue, up another 26% this year, an outsized gain that can be attributed in part to the deep corporate tax cut but also to strong global growth.

And, as in the past year, those rising earnings were one of the main points many stock market strategists mentioned on Monday morning as to why any massive market sell-offs were unlikely. I pointed to still relatively low interest rates as the reason investors shouldn’t get overly nervous about the bull market ending.

Earnings, it turns out, are not as good a defence for the market as it seems. The general notion that stocks can’t fall unless earnings do was reinforced by recent history. Earnings fell nearly 46% and 90% in the past two bear markets in 2000 and 2007, respectively. But, according to data from Birinyi Associates, go back a little further, and there has been less of a correlation. In the 1987 bear market, earnings rose just more than 10%. The stock market sell-off of the early 1970s had earnings growth of more than 30%. “One of the best years for earnings was 1994, a flat year for the market," says Jeff Rubin, director of research at Birinyi. “It’s not something we put a lot of stock in."

Bank of America, too, raised some warning flags on Monday about counting too heavily on earnings as a market backstop. According to the bank’s research, in the past 90 years, the stock market has been down 29 of them. Only nine of those down years have also had negative earnings growth. Profits have risen in the other 20. And in about half of those down years, profit growth has been in the double digits.

The reason has to do with inflation, which has been missing the past few years but some fear is coming back. When earnings rise quickly, prices often do as well. That causes the Federal Reserve to raise interest rates, which is bad for stocks and tends to have more pull on the stock market than what companies are expected to earn in the next 12 months. Many stock market investors appear to have been betting on a return to a so-called Goldilocks economy, with rising growth and low inflation. Instead, the rebounding global economy mixed with the massive tax cuts may have pushed the market into too-hot territory, and investors are no longer willing to stick around to find out. Bloomberg Gadfly

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