As we know, publicly traded companies report their financials on a quarterly basis, so we have regular opportunities to learn what is happening with profits. Due to seasonality factors, stock analysts typically compare the quarterly earnings of a company or group of companies to the same quarter the previous year to determine growth rates. Over the last eight or so calendar quarters, as markets have largely moved sideways and have been punctuated with volatility, we have seen a deterioration in corporate earnings. In fact, quarterly operating earnings for the S&P 500 peaked in Q3 2014 at $29.60 per share. The same quarter the following year resulted in $25.44, and Q3 2016 is expected to result in approximately $24.90. The annual totals have also shown deterioration.

As mentioned above, over short periods of time we often see a disconnect between current earnings and stock prices. This is largely because the stock market is continually looking at future earnings, and discounting them to arrive at a current price for a security. For example, if a company reports that earnings have been impacted negatively in the current quarter by a one-time event, investors are likely to look at the impact of that event on future earnings, and perhaps ignore it if they believe that a rebound is likely. Thus, for a period of time until annual earnings confirm the stock price, one might observe that the stock price didn’t follow the company’s earnings. During this period, we would see the stock valued at an unusually high price/earnings (P/E) ratio. If earnings continue to deteriorate, it’s likely that eventually investors will be less inclined to pay an elevated price for the company, and the P/E and price will move lower.

So if Profits Are Deteriorating, Why Are Stock Prices Reaching Record Highs?

A closer look at the situation reveals that while we have several factors affecting the overall profitability results for the group of companies known as the S&P 500, a look under the hood reveals that the headline number may not tell the whole story.

Profits in the Energy Sector Have Been Flattened

We’ve all witnessed the deterioration, then partial recovery in oil prices that has occurred over the last couple of years. In fact, the deterioration in that sector accounts for a meaningful part of the overall decline. For the second quarter of 2016, Energy Sector earnings were off a whopping 84.1% from the same period in 2015 (Source: FactSet Earnings Insight, September 16, 2016). Bear in mind that the Q2 2015 earnings were themselves down 55.6% from the second quarter of 2014 (Source: FactSet Earnings Insight, August 28, 2015) and you can see the magnitude of the issue.

The Strong Dollar Has Hurt Profits

For U.S. companies doing business abroad, the strengthening of the Dollar against many foreign currencies has been a headwind to profits. As those sales made in foreign currencies are converted back to U.S. Dollars (whether through being repatriated or converted for bookkeeping purposes), the profit of those sales is diminished. This has been a challenge for multi-national companies for some time, but to the extent that the Dollar stabilizes, even at a relatively high level, this factor should have less negative impact.

With Historically Low Bond Yields, Investors Are Turning More and More to Stocks for Return Potential

Clearly, the low rate policy in this country, as well as the negative rate scenario we are seeing in other countries, is pushing investors more and more to stocks to seek returns. While on a P/E valuation basis U.S. stocks are above their 5- and 10-year averages, we continue to see investors seeking returns either through dividend paying stocks, or by taking a total return approach to replace lost bond income. This new demand for stocks may be a meaningful factor supporting stock prices in this market.

So Where Do We Go from Here?

We think that while we may see interim volatility on the order of what we’ve witnessed on several occasions over the past couple of years, moderate growth of the global economy and slightly higher growth in the U.S. will continue to support the secular bull market we’ve been in for several years.

Within the S&P 500 profit picture, the challenges being faced by the Energy Sector and its impact on the headline number by no means tell the entire story. In fact, consumer sectors, telecom services and others continue to enjoy growth in profitability. The U.S. economy, while growing at a slower than average rate, continues to improve.

So while 2015 and 2016 have been challenging to some sectors from a profitability basis, we anticipate a return to overall S&P 500 earnings growth taking place late in 2016 or in early 2017. We think that a moderate overall increase in earnings could serve to confirm current market valuations, and support higher valuations in the future as prospects for further profit growth become more evident.

As described earlier, insightful investors often look past current events to future developments to inform their decisions. As we at Atlas move forward, we will do the same on behalf of our valued clients.

ARTICLE WRITTEN BY:
John C. Ogle
Chief Investment Officer
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