It's Not Just the Fed and Trump That Trouble the Stock Market

(Bloomberg) -- In a week when just a few words from Jerome Powell and Donald Trump were enough to send stocks reeling, it's easy to conclude their pronouncements are all that matter to markets right now. But something else keeps showing it can sway prices: bad earnings.

While investors clearly were glued to every word from the central bank and president, the reporting season showed that fundamentals still matter, particularly in a market as richly valued as this one. Falling short of earnings forecasts has led to swift consequences.

Among S&P 500 companies that have reported second-quarter results, those whose trailed analyst estimates saw their stock lagging behind the market by 3 percentage points the day after, data compiled by Goldman Sachs showed. Meanwhile, beats were rewarded by gains of 1.43 percentage points. The spread, more than 4 points, was the third biggest since 2012.

The divergence in performance shows that even in an environment where macro concerns seem to dominate, getting stock selection right still has consequences. Earnings haven't lost their ability to move markets -- something else to worry about as companies slash their forecasts at the fastest rate in four years.

“Investors are worried, they're anxious, they're looking for reasons to sell,” Chris Gaffney, president of world markets at TIAA Bank, said by phone. “Earnings expectations have been lowered. When you miss those lowered expectations, you're going to get punished.”

It's a message that is easily lost if all you do is stare at the market's surface. Broadly, stocks have been chained to every turn in monetary and trade policy. The S&P 500 tumbled after Fed Chairman Powell called Wednesday's interest-rate cut a “mid-cycle adjustment,” denting hopes for a full-blown easing cycle. They dropped again after Donald Trump said he'll impose new tariffs on Chinese goods and just posted the worst week of the year.

Amid all the noise, it would be easy to brush aside the importance of earnings. But equity reactions to individual announcements show the market is becoming less forgiving at the company level.

Even after last week's drop, the S&P 500 is up 17% this year despite no profit growth to speak of, while valuations have expanded at the fastest pace in a decade. At 16.7 times forecast earnings, the index was trading at an 11% premium to its 10-year average.

Some of the optimism is linked to expectations companies will ratchet up growth to almost 6% in the fourth quarter and then 10% for the whole year of 2020, data compiled by Bloomberg showed.

The expected rate of acceleration is too optimistic, according to strategists at Citigroup and Goldman Sachs. Both firms predict an increase of no more than 6% for next year.

Trump's planned 10% tariffs on additional $300 billion of Chinese goods would trim the S&P 500's profit growth by 60 to 70 basis points as input costs rise and corporate confidence weakens, according to an estimate from Bank of America.

Companies are lowering their guidance. Among those that have provided forecasts for the third quarter, more than half were below analyst estimates, the worst since 2015, data compiled by Bloomberg showed.

The combination of elevated valuations and deteriorating earnings can be trouble for stocks, according to Jeff Mortimer, director of investment strategy at BNY Mellon Wealth Management, which has about $253 billion under management.

“There are stocks that have gotten over their skis,” he said. “When that air pocket faces reality, you get a pullback.”

To contact the reporters on this story: Lu Wang in New York at lwang8@bloomberg.net;Vildana Hajric in New York at vhajric1@bloomberg.net

To contact the editors responsible for this story: Jeremy Herron at jherron8@bloomberg.net, Chris Nagi

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