2 Reasons Why Robust Earnings Could Actually Hurt Stocks

Q2 2018 earnings season is approaching the late innings, and all signs point to favorable, strong results. As of August 3, the results for 381 S&P 500 members are in, with earnings for these companies up 25 percent from the same period last year on 10.4 percent higher revenues (according to Zacks Investment Research). Over 80 percent of the 381 reporting companies exceeded earnings estimates, with 73.8 percent beating revenue estimates.

Plain and simple: earnings growth is robust in America today.

But the irony of robust earnings is that they can also be a cause for concern for stock prices. Here are two reasons why.

Reason #1: When Expectations Exceed Reality, Stocks Suffer

The stock market likes positive surprises, not negative surprises. If a corporation estimates they’re going to earn $1 per share in earnings, and the actual numbers come in at $1.40, the stock price is almost sure to jump. The opposite also tends to be true, where a stock gets punished for falling short.

Strong double-digit earnings growth over the last six months, while welcome, has also set the expectations bar very high for corporate America. 20+ percent earnings growth cannot last forever – in fact, it may not even last another quarter.

The question is: how will investors and the market react when corporations can no longer deliver such robust earnings growth? Will stocks suffer?

The tailwind effects of the corporate tax cuts are likely to wear off in the coming quarters, and the concern becomes that investors are now wired to expect this powerful growth to continue – but may be royally disappointed when it doesn’t.

Reason #2: Compressed Multiples May Send the Wrong Message

As earnings have soared in 2018, multiples (valuations) have compressed across just about every sector in the S&P 500. As a refresh for readers, valuation is measured by P/E ratio, or the Price/Earnings ratio. As earnings (the denominator) rise, the P/E ratio falls, indicating that stocks are cheaper. Generally speaking, that’s a great thing.

Investors who note a falling P/E may see it as an opportune time to buy. But that’s also the issue. To the extent that robust earnings growth was/ are transitory based on the impact of the tax cuts, multiples seem likely to move higher again, once earnings cool off. The idea that investors are ‘buying the dip’ in valuations may just be an illusion fueled by tax cuts.

The Bottom Line

Strong earnings are arguably one of the most commonly given reasons today for being bullish, which is fair – earnings have indeed been soaring, and corporate America is arguably as healthy as ever with its highest earnings growth rates in nearly seven years. Revenues are also growing, which is a sign that corporate strength is not singularly tied to the tax cuts. Overall economic strength is playing a key role.

But it is also important to remember that we are now just months away from this expansion being the longest ever recorded in U.S. history, and as the effect of the tax cut fades, one wonders how much longer the business cycle itself can press on. What goes up does not necessarily have to come down, but history tells us that it always does eventually.

Ed Flores is the editor-in-chief of Tickeron.com. He was formerly a finance writer at a $40 billion asset management firm and has been in the asset management business since 2006. He focuses on equity markets and global economics.