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Investment Ideas Goldman Sachs says market melancholy sets the stage for a big earnings season

Earnings season has arrived at another critical spot for stocks, and traders are being haunted by what happened last time.

They’re thinking about April, when a 24 per cent surge in corporate profits did nothing to lift a market that had just been walloped by its second selloff in as many months. Sure, ground has been reclaimed since, but today the S&P 500 is perched at a point where three previous rallies failed. What happens if the July reporting season is another dud?

Relax, says Goldman Sachs – enough has changed that a replay is unlikely. Bulls should take heart, says David Kostin, the firm’s chief U.S. equity strategist, because whatever euphoria infected markets in the first part of the year has long ago dissipated. Hedge fund clients who were aggressively positioned heading into April are more conservative now, with exposures sitting near the bottom of their 12-month range.

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“Going into Q1 earnings season, it was peak optimism,” Jeff Schulze, an investment strategist at ClearBridge Investments in New York, said by phone. “Now you have exactly the opposite situation where that optimism has been converted to pessimism. As long as companies can hit those estimates, I think the market will reward those, rather than punishing them.”

Fundamentally, the second quarter will look a lot like the first as far as results go. S&P 500 companies are forecast to report 20 per cent growth from a year ago and sales are likely to rise 8 per cent, mirroring the previous period, which was the best since 2011.

And while the market has made unsteady progress since April – up about 8 per cent – the S&P 500 has yet to prove it is able to overcome a round-number barrier where advances fizzled in February, March and June.

The 2,800 level, which the S&P 500 surpassed in January for the first time ever, is again within reach just before banks unofficially kick off the earnings season Friday. The index rose for a fourth day Tuesday, climbing as high as 2,795.58, as traders brushed aside a trade war between the U.S. and China.

For equity bulls, the market better come to terms with earnings this time around. Three months ago, an unprecedented round of positive surprises was met with muted reactions in stock prices as investors fretted growth may have peaked after tax cuts.

Valuations have become less of an issue since January, thanks to profit expansions and lower share prices. At current levels, the S&P 500 trades at 17.5 times forecast earnings, matching the average over the past five years.

Analysts predict double-digit income growth in 2019 and 2020 too, with estimates holding steady since the last reporting season. Should those long-term forecasts come true, the market only looks cheaper going forwards.

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Using next year’s projections of $176 a share, the S&P 500’s price-earnings ratio falls to 15.9.

“I do think earnings will be good enough to blow through there and take some of the lagging names up with it,” JP Gravitt, chief executive officer and market strategist for Market Realist, said in an interview at Bloomberg’s New York headquarters. “And then I think we’re going to be kind of left pulling the bag like, ‘What now?”’

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