The bull is on: Earnings clobber lacklustre expectations

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Companies tend to report earnings that beat the low-ball expectations set by analysts – but the first quarter reporting season, which is just wrapping up, looks set to be particularly good.

No, earnings haven't blossomed by double digits. But they have pulled off impressive growth that is easing concerns that corporate growth is tapped out.

That's giving investors a good reason for sticking with the bull market. The S&P 500 approached a new record high close of 1895 in afternoon trading on Monday. The index has risen about 2.5 per cent since the first quarter earnings season began on April 8.

Based on the earnings from more than 90 per cent of companies within the S&P 500, earnings growth has risen by slightly more than 5 per cent over last year, according to Bloomberg News. Heading into the season, analysts had been expecting earnings to be virtually unchanged, marking a worrisome slowdown.

The pleasant surprise is a bit of a head-scratcher, given that the U.S. economy grew just 0.1 per cent in the first quarter, at an annualized pace. Jonathan Golub, chief U.S. market strategist at Royal Bank of Canada, pointed out, though, that earnings and economic growth can be difficult to compare: Earnings are compared year-over-year, while economic growth takes a quarter-by-quarter perspective and is seasonally adjusted.

If you look at them the same way – year-over-year – then economic growth looks considerably better, growing at a 3.7 per cent clip.

What's more, things like lower government spending and higher imports have weighed on gross domestic product but aren't tied to corporate earnings. Account for these issues and GDP looks even better.

Economists expect U.S. GDP to pick up in the second quarter, to 4.1 per cent year-over-year. But what does that mean for earnings and the stock market?

"As we look toward the second quarter, stronger economic growth is one reason corporate results are expected to improve," Mr. Golub said in a note. He believes earnings growth should improve by about 2 percentage points.

Michael Hartnett, chief investment strategist at Bank of America, is similarly upbeat in the near term, noting that the U.S. economy is in the midst of its most sustained period of growth in nearly a decade.

"New highs in equities are likely to be aided and abetted by 'irrational exuberance' in both credit markets and carry trades," he said in a note.

But he believes the good times are going to end when investors start to anticipate the first interest rate hike by the U.S. Federal Reserve later this year.

"When the end of zero rates is threatened, likely this autumn as unemployment rates drop to uncomfortably low levels, both credit & stock markets should correct sharply," Mr. Hartnett said.