Analysts Reconsider Earnings Euphoria as Investor Bliss Persists

(Bloomberg) -- If stocks anticipate profits, investors clearly expect something big when companies start reporting results next week. The S&P 500 Index has climbed 3.6 percent in a month, the best pre-earnings season in five years.

But don't tell that to Wall Street analysts, who have cut their estimates for S&P 500 income growth by more than half. At 3.6 percent, they're now predicting the biggest slowdown since 2011 after profits expanded about 11 percent in the March-June quarter.

Yes, earnings are still increasing, and yes, a lot of the revision reflects the impact of hurricanes. But at minimum the buoyancy is a case study in the glass-half-full attitude that has marked investor sentiment for more than a year, a stretch in which they've brushed aside everything from North Korea to Brexit and Donald Trump's political entanglements.

Add to that valuations that by some definitions exceed any but those at the top of the Internet bubble, and you have a recipe for anxiety among fund managers.

“Suddenly, you are in a situation where you're ignoring all the bad news, full speed ahead. Then a torpedo hits and you're going to be blown up,” said Tom Mangan, senior vice president of James Investment Research in Xenia, Ohio, which oversees about $6 billion. “We have a market that is expensive relative to most of the time, and it's vulnerable.”

While analysts always lower their expectations heading into earnings season, the 4.9 percentage-point reduction is almost double the average cut in the past year. All 11 industries suffered downward revisions, with financials and consumer discretionary seeing growth estimates going from positive to negative. 

Insurers are likely to report a 41 percent drop in profits as costs surged during the deadly storm season. Automakers and airlines may see income contracting more than 9 percent because of lost business during the natural disasters.

Investors don't mind. They're focused instead on the prospects of tax cuts in the U.S. and a global economic recovery, drivers that are expected to help prolong the profit cycle.

Weekly Gain

The S&P 500 rose 1.2 percent over the week just ended, hitting a sixth consecutive record high before falling on the final day. At 19 times forecast earnings, the index trades near the highest valuation since the dot-com era.

According to Sanford C. Bernstein, it doesn't matter what earnings are doing as long as they're going up. The New York-based brokerage studied equity performance in the past 27 years and found that equity returns are roughly the same at about 3 percent over three months regardless if growth is slowing or not. It's when profits are falling that stocks get into trouble.

Analysts don't see growth turning negative any time soon. In fact, they expect a rebound starting in the fourth quarter, with earnings expanding at an average 11 percent through June, data compiled by Bloomberg show.

“We are not particularly concerned by this slowdown,” said Noah Weisberger, a strategist at Bernstein. “We would use any potential market jitters around 3Q numbers to re-engage more forcefully with our bullish bias.”

With hurricanes muddling the earnings picture, Phil Orlando, chief equity strategist at Federated Investors, said he'll be listening to corporate management to determine whether the deceleration signals a peak in profit growth.

“It comes upon them to give us some insights into how much of an impact that the storms had and whether or not their businesses are going to bounce back in the fourth quarter,” Orlando said. “The guidance becomes as important if not more important than the actual results. In an absence of any guidance, it potentially could be ugly.”

To contact the reporter on this story: Lu Wang in New York at lwang8@bloomberg.net.

To contact the editors responsible for this story: Arie Shapira at ashapira3@bloomberg.net, Chris Nagi, Richard Richtmyer