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scott barlow

A terrible U.S. earnings season might be the only explanation we need for market volatility.

The first chart here compares the year-over-year return for the S&P 500 with the year-over-year percentage change in 12-month earnings per share. Outside of the madness of the financial crisis, the two lines move closely together.

Looking at the past three years, the chart also makes clear that U.S. profit growth peaked in September, 2014, at 9.4 per cent and headed straight south since. Currently, with 373 S&P 500 companies reported, year-over-year profits have shown a decline of 8.9 per cent.

The profit decline has occurred despite Herculean efforts of financial engineering, primarily in the form of share buybacks. (Buybacks flatter EPS reports by decreasing the size of the denominator – the same amount of profit results in higher EPS after buybacks.) In March, Bloomberg reported that S&P 500 companies were on pace to buy back a near-record $165-billion (U.S.) in stocks while investors were withdrawing funds from mutual funds and exchange-traded funds at a rapid pace.

Most investors are aware that earnings growth is the main driver of stock prices, but the practice of corporate guidance and "beat rates" has helped disguise the full extent of the slowdown. Last Thursday morning, for instance, a Bloomberg story headline, "Shell Quarterly Profit Beats Estimates on Refining Earnings," suggested things were great for Royal Dutch Shell shareholders. The company did beat analyst earnings expectations – which are often based on management guidance – but profit was lower by 58 per cent versus 2015.

Energy and materials stocks have done a lot of damage to overall earnings growth, but they are far from the only detractors. Profit growth for the financial sector so far shows a 13.3-per-cent year-over-year decline. Earnings growth in the formerly high-flying technology sector have been reported lower by 9.9 per cent and profits for U.S. utilities are down 4.8 per cent.

The market volatility in January caused a sharp 3-per-cent drop in 2016 S&P 500 consensus earnings expectations from $120.68 a share to $117.14. This means the U.S. equity benchmark is trading at an expensive 17.5 times estimated earnings.

It gets worse. In a research report released Friday, Merrill Lynch chief quantitative strategist Savita Subramanian wrote that first-quarter profits are likely to come in at a $26.67 a share. If this pace continues throughout the year, the S&P 500 is trading at an even more expensive 19.2 times forward earnings.

There are no doubt still-promising investments in the U.S. equity markets – profit growth in telecommunications and health care look very solid – but in aggregate, the S&P 500 is currently an expensive market with declining earnings growth despite widespread buybacks. Is it any wonder things got volatile?

Follow Scott Barlow on Twitter @SBarlow_ROB.