Global corporate profitability is on the verge of rising to unprecedented levels, which could provide crucial support for richly priced stocks.
For the first time ever, the outlook for global earnings over the next year is poised to remain above $30 (U.S.) a share for companies in the MSCI all-country world index, according to Jeffrey Kleintop, chief global investment strategist at Charles Schwab & Co. Inc.
"Without a rise in earnings above $30, stock prices may find it difficult to move any higher. Fortunately, that now appears more likely than it has in a decade," Mr. Kleintop wrote in a report.
Equity valuations in many of the world's major markets sit at multiyear highs, making stocks increasingly vulnerable to negative shocks. A boost in earnings expectations would help justify equity prices.
And just in time, perhaps. In some senses, the market seems to have grown unimpressed with the current pace of earnings growth. Amid a solid earnings season in which S&P 500 companies have posted a second-straight quarter of double-digit growth, U.S. earnings beats are being met with indifference.
"Investors did not reward firms that beat expectations in [the second quarter]," said David Kostin, Goldman Sachs's chief U.S. equity strategist, in a note last week.
Over the past decade, companies surpassing analysts' profit estimates outperformed the S&P 500 by an average of 114 basis points the day after reporting.
This earnings season, the excess return has amounted to a measly three basis points – "the lowest level on record," Mr. Kostin said.
In the inability of earnings surprises to drive the market, some see an ominous sign.
Merrill Lynch called it a "potentially concerning anomaly." BlackRock strategists wrote that "investor sentiment shows more signs of fatigue than euphoria."
One possible explanation for the muted reaction to earnings season is that top-line growth has been far less impressive.
With all but a couple of dozen companies left to report second-quarter performance, S&P 500 index revenue growth is tracking 5.1 per cent higher than last year, compared with 12.1-per-cent growth in earnings per share (EPS), according to data provided by Thomson Reuters.
"The concern is that unless we increase margins forever, earnings growth would at some point be cut in half," said Avery Shenfeld, chief economist with Canadian Imperial Bank of Commerce.
Another culprit is the performance of U.S. equities so far this year, as valuations came to capture a great deal of investor optimism.
In fewer than six months up to the unofficial start of earnings season, the S&P 500 index gained 10 per cent, putting it on track to be the second-best calendar year of the bull market.
"The expectations on what U.S. companies could deliver were very high heading into the quarter," said David Rosenberg, chief economist at Gluskin Sheff + Associates.
This stands in contrast to the recent performance of Canadian equities. With the S&P/TSX composite as the only major country index down year to date, there was more room for Canadian earnings surprises to provide some upside.
And indeed, Canadian second-quarter earnings beats have produced a relatively healthy average two-day price reaction of 1.4 per cent, according to Thomson Reuters.
Sentiment toward U.S. stocks may now need to see an improvement in the earnings outlook. While further growth is expected in the back half, the rate of growth for S&P 500 companies' profits in the third quarter has declined to 6.7 per cent, compared with an estimate of 8.6 per cent at the start of July.
But U.S. corporations have also given some positive signals, with fewer negative revisions and more positive earnings revisions than average coming out of earnings season, according to FactSet.
And the global trends still look broadly supportive of corporate earnings.
For the first time since 2010, all of the world's 20 largest economies are growing this year, according to the Charles Schwab report. And the International Monetary Fund expects the global economy to gather steam in 2018.
"The strongest and broadest global economic growth in years supports a lift in earnings above $30 for the first time ever," Mr. Kleintop wrote.