The Greek philosopher, Heraclitus, is credited for the famous saying, “change is the only constant in life.” My, how things have changed, and for the better!
The grim macro backdrop of 2014 ̶ 2016 (e.g., slowing global growth, a strengthening U.S. dollar, weakening commodity prices, U.S. producer price deflation, as well as falling U.S. sales and earnings growth) has given way to a complete reversal of fortune.
Now, global growth is accelerating, the U.S. dollar is weakening, commodity prices are strengthening, producer prices are rising, and a budding sales and earnings recovery are in tow.
Q4 2016 Earnings Look Good, 2017 Earnings Look Even Better
Almost 100% of S&P 500 companies have reported earnings for the fourth quarter of 2016 and, after six consecutive quarters of declines, trailing four-quarter operating earnings per share (EPS) have increased for the first time by 6% year-over-year to $106. Interestingly, S&P 500 12-month forward EPS have increased by just 9% year-over-year to $134.
While the levels of trailing and forward earnings aren’t directly comparable, the growth rates probably are. The fact that trailing earnings are already recovering at a rate similar to forward earnings suggests that expectations for growth may be too low, potentially setting us up for a string of positive surprises.
Macro Momentum Alone Can Deliver Strong Earnings
Why do we focus on macro momentum, and what does the cyclical economic upswing mean for corporate profits?
In Exhibit 1, we show the Institute for Supply Management’s (ISM) Manufacturing Purchasing Managers’ Index (PMI) – a macro momentum proxy – alongside S&P 500 trailing 12-month operating EPS growth since 1998. The two variables carry a correlation coefficient of 0.72, meaning they have a strong, positive, linear relationship.
We advanced the ISM Manufacturing PMI by four months to illustrate that it’s a forward-looking, cyclical indicator of overall business activity. Diffusion indices like this have the properties of leading indicators, and are convenient summary measures showing the prevailing direction and scope of change.
The current reading of 57.2 is well above the break-even line of 50.0, and suggests the manufacturing side of the economy and broader corporate profits should continue to expand at a robust clip.
Why do we look at the manufacturing sector, rather than a wider measure of economic activity?
True, the manufacturing side of the U.S. economy isn’t as big as it was several decades ago. However, it remains an important marginal “swing factor” for economic growth, while the services side of the economy is generally more stable.
Conceptually, manufacturing activity touches nine of the 11 sectors of the S&P 500, which also helps explain why the ISM Manufacturing PMI has been a good leading indicator for corporate profits over time.
Finally, the ISM Composite PMI (Manufacturing + Services) doesn’t lead S&P 500 earnings growth, and has a significantly weaker correlation coefficient of 0.58.
Expect Modest Returns on U.S. Stocks, Driven by Earnings
In typical late-cycle fashion, inflation is picking up, the Federal Reserve (Fed) is raising rates in response, and has even begun talking about balance sheet normalization, all of which are headwinds to P/E multiples.
Why shouldn’t investors sell stocks?
In our view, the earnings outlook is brightening, providing an important offset to potential P/E multiple compression. The real “show stopper” and signal to sell stocks would be an economic contraction, which we don’t see in the cards right now.
As the aging bull market transitions from a high-octane, early-cycle phase (driven by P/E multiple expansion) to a lower-intensity, later-cycle phase (driven by earnings), we think investors should curb their enthusiasm for returns, but stay invested in U.S. equities.
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