Expectations for corporate earnings are tumbling, but investors would never know it from the stock market.
The S&P 500 hit a fresh record high on Tuesday, a week ahead of the official kick-off to the first-quarter reporting season.
Despite the market gains, earnings optimism is hard to find right now. Companies and analysts are busily slashing profit estimates to levels that raise concerns about stocks' lofty valuations following five years of gains.
According to S&P Capital IQ, 110 companies in the S&P 500 have provided guidance on the earnings results to expect in the weeks ahead; 75 of them have lowered their expectations.
Analysts are following suit. They are predicting earnings will rise a mere 0.38 per cent over last year which, if correct, would be a stunning slowdown from earnings growth of 8.5 per cent last quarter and mark the slowest first-quarter growth during the economic recovery.
The downbeat outlook for earnings season comes at a potentially delicate point for the stock market. The S&P 500 has risen more than 180 per cent from its bear market low in 2009, driving its price-to-earnings ratio above 17, based on trailing earnings. That is near the high end of its historical range, and fits in with widespread concerns the market is fully valued.
Strategists at Goldman Sachs, for example, believe the S&P 500 will follow earnings growth – which isn't an upbeat outlook if earnings are set to idle.
The S&P 500 closed on Tuesday at 1885.52, up 13.18 points or 0.7 per cent. The Goldman strategists' year-end target for the S&P 500 is 1900, implying a gain of just 1 per cent from the current level.
Bank of America is considerably more bullish. However, its target of 2000 is just 6 per cent away.
While the prospects for big gains may be limited, few observers see any reason for alarm in the state of corporate earnings growth.
According to John Butters, senior earnings analyst at FactSet, it isn't unusual to see the S&P 500 rise even as analysts slash their estimates: It has occurred in 14 of the past 20 quarters.
During these 14 quarters, he said, analysts have lowered their earnings forecasts by an average 3.1 per cent, and the index has risen an average of 8 per cent.
The current pessimism about earnings may partly reflect management's usual attempts to manage expectations. By lowering estimates for earnings, a company improves the chances it will deliver better-than-expected results – and so-called "beats" tend to give share prices a nice boost.
Last quarter, more than 70 per cent of companies in the S&P 500 cleared forecasts that had been lowered substantially prior to the rollout of earnings.
Stéfane Marion, chief economist and strategist at National Bank Financial, says low interest rates will support current valuations, while many companies should be able to beat reduced expectations.
"This 'beat' ability is likely to be sustained against a backdrop of an improving economy … low corporate default rates and accommodative monetary policy," he said in an e-mail.
A backdrop of encouraging economic data helped markets gain ground on Tuesday. The Institute for Supply Management's manufacturing index moved higher in March, suggesting that the economy is recovering from a weather-related slowdown earlier in the year.
Investors also liked what Federal Reserve Chair Janet Yellen said on Monday, when she provided assurances that the central bank will keep its key interest rate low. Countering earlier views that the Fed was now determined to raise rates early next year, she noted that economic activity and the labour market are not back to normal.
They are expected to improve, though: When the U.S. Labor Department delivers its monthly payrolls report on Friday, economists are forecasting impressive job gains of 200,000, along with a dip in the unemployment rate to 6.6 per cent from 6.7 per cent.