As is often the case, two major areas of interest are sending mixed signals with regard to where the equity market heads next. Corporate profits (as well as revenues) are suggesting more gains lay ahead, while the bond market, in all its infinite wisdom, is pointing towards a slower growth environment.
Which one will ultimately be correct? Let’s find out, beginning with corporate earnings.
It’s no secret that major corporations posted strong results in Q1. With 99% of the S&P 500 having reported, the blended earnings growth rate for the first quarter stands at 14.0% (FactSet). This is the strongest earnings growth we’ve seen since Q3 2011 when profits rose by 16.7%.
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The natural inclination is to assume that this tremendous growth is simply the result of energy sector earnings, which have rebounded substantially from year-ago levels. While there is some truth to that, it’s not the whole story.
During the first quarter of last year, the entire energy sector posted a loss of $1.5 billion. This makes it impossible to calculate an energy-sector specific growth rate (notice the omission in the chart below), but on a dollar-level basis, the energy sector generated $8.5 billion in profits during Q1 2017. This means that energy was the largest contributor to earnings for the quarter. Excluding energy, the rest of the S&P 500 would have posted an aggregate earnings growth of 9.8% – still not bad at all.
The table below shows Q1 earnings growth by sector.
Since the great recession, a common theme with corporate earnings has been the lack of revenue growth. Seemingly unable to grow top line revenues at a fast pace, many companies have resorted to expansive cost-cutting measures to trim fat and meet earnings growth targets.
But during the first quarter of 2017 even revenues came in healthy. The blended revenue growth rate for Q1 is 7.6%, which is the highest since Q4 2011. If the anomalous energy sector is once again excluded, revenue growth falls to 5.8%, which really isn’t all that bad considering we remain in a 2% economy.
If you’d like to know which sectors posted the strongest revenue growth, take a look at the chart below.
So revenue and earnings in the first quarter came in strong, but what about the rest of the year?
Taking into account the rose-colored glasses that are mandatory apparel for financial analysts, earnings and revenue growth are expected to continue throughout 2017. The table below summarizes current projections by quarter and also for 2017 as a whole.
If we do see corporate profits grow by 9.9% this year, it will help justify stock prices at current levels, and may even help push them higher. This view jibes with the current price action in the market and suggests the bullish primary trend is set to continue.
But other segments of the financial arena are giving off warning signals, particularly the action in the bond market. Let’s begin with the action we’re seeing in the 10-year Treasury.
As you can see in the chart below, the bellwether 10-year Treasury note yield has been falling for the past few months.
After rising from July - November 2016, interest rates got a boost following the election. This catalyst took interest rates up into a channel (red box) where they traded in a sideways range between 2.3% - 2.6% for roughly five months. Then, beginning in mid-March, rates began to head lower and traced out a pattern of lower lows and lower highs. Recently, the yield on the 10-year note just broke through support (including the 200-day MA) near 2.2%.
This decline in yield on the 10-year note is indicative of a lower growth outlook for the economy. But what exactly is causing this? The answer, of course, is inflation expectations.
Let’s begin with a look at the Fed’s preferred measure of inflation, Personal Consumption Expenditures (PCE). Headline inflation is shown in dark blue, while core inflation (excluding food and energy) is shown in light blue.
As you can see, after momentarily reaching the Fed’s 2% inflation target, headline inflation has backed off. At the same time, core inflation, which tends to be much more stable, has also taken a leg down.
Part of the reason for this has to do with what we’re seeing in commodity prices. In the chart below, which shows the CRB Commodity Index, we can see that while commodity prices still remain inside a year-long channel, they’ve been heading south for most of 2017.
What makes matters here a bit worse is that this index is on the verge of retesting a strong area of support near 176. If this area of support fails, it could signal a period of even lower commodity prices ahead, which would reinforce the downward pressure on inflation.
From an investor perspective, we can see exactly what the drop in commodity prices and historical inflation has done to expectations via this next chart.
This chart, which shows the 5-year breakeven rate for inflation, highlights the decline in inflation expectations that we’ve seen recently. It should come as no surprise that this is feeding directly into the price action in the 10-year note, causing yields to fall.
What’s interesting about this whole setup is that corporations generally need a stronger economy to grow revenues and earnings, and that stronger economy usually reveals itself in the form of rising GDP and inflation. So what gives?
I wish I had a succinct answer here, but unfortunately, I do not. Perhaps the economy has picked up momentum and it’s just that the Q1 GDP reading (1.2%) was anomalous, as it has been in previous years. This is certainly the take from the Atlanta Fed’s GDPNow tool, which is currently forecasting second quarter growth of 3.4%.
On the other hand, it’s possible that we remain in a 2% economy (a very likely scenario), and that much of the S&P 500 earnings and revenue growth has been aided by sales from abroad.
A quick look at the dollar index shows that the dollar has been declining since the beginning of 2017, and declined substantially during the first quarter.
This made exports cheaper throughout Q1, which may have boosted sales for multi-national companies while also helping to translate overseas revenue into more bottom-line dollars. The continued decline in the dollar during Q2 suggests that we may have this tailwind behind us when companies go to report second quarter earnings as well.
So rather than suggesting that corporate earnings are right and the bond market is wrong, or vice versa, the prudent thing to do is recognize that the real answer probably lies somewhere in the middle.
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Interestingly enough, the falling 10-year yield will actually have a stimulatory effect on the economy, as it represents a reduction in borrowing costs that will impact large swaths of business and consumer borrowing (think mortgage rates, as an example, which key off of the yield on the 10-year note). Lower long-term rates were, after all, the exact intention of quantitative easing (QE).
With the dollar continuing to decline, interest rates (at the long end of the curve) more simulative than they were just a few months ago, and corporations still forecasting earnings growth in the upcoming quarters, my inclination is to continue betting on higher stock prices ahead. This view is also backed up by the price action in the major averages, which suggests that the bullish primary trend is very much intact.
The preceding content was an excerpt from Dow Theory Letters. To receive their daily updates and research, click here to subscribe. Matt is also the Chief Investment Strategist at Model Investing. For more information about algorithmic based portfolio management, click here.
