Q2 2018 earnings season is just around the corner in the 2nd half of July. Corporate earnings are expected to grow 20% year-over-year, much of which is due to Trump’s tax cut.
In this post we’re going to look at:
- How to use corporate earnings to predict the stock market’s future direction.
- The wrong way to use corporate earnings to predict the stock market.
- Q2 2018 earnings season will be strong, which is medium-long term bullish for the stock market.
How to use corporate earnings to predict the stock market’s future direction
As we consistently demonstrate here at BullMarkets, the stock market and economy move in the same direction in the medium-long term.
Here’s another fact. The stock market and 12 month forward earnings (future expected earnings also move in the same direction in the medium-long term. As you can see in the following chart, 12 month forward earnings go up during bull markets and go down during bear markets.
12 month forward earnings for the S&P 500 are predicted by financial analysts.
- Analysts’ earnings forecasts tend to be pretty accurate (“misses” are usually miniscule). The only time analysts are wrong is when the economy slumps into a recession, because analysts don’t have the ability to predict recessions that cause corporate profits to fall across-the-board.
- Corporate profits usually trend higher throughout the course of an economic expansion, unless oil prices crash 50%+ (which causes energy sector earnings to slump). This is what happened in 2015.
Hence, what we know is that corporate earnings trend higher nonstop in the medium-long term unless the economy enters into a recession or oil prices crash.
Remember: the U.S. stock market and corporate earnings move in the same direction (up/down) in the medium-long term. This means that the stock market doesn’t care about the RATE of corporate earnings growth in the medium-long term (e.g. 20%, 15%, 10%). What matters is whether or not earnings ARE growing (i.e. is earnings growth above 0% or below 0%).
- If corporate earnings are going UP (regardless of the rate of growth), that is medium-long term bullish for the stock market.
- If corporate earnings are doing DOWN (regardless of the rate of deterioration), that is medium-long term bearish for the stock market.
The wrong way of using corporate earnings
There’s a lot of BS that’s thrown around in the financial industry.
BS #1: trying to predict “what’s priced in” to the market
A lot of professional traders and analysts try to guess what’s “priced in” to the markets. For example, they’ll say “strong earnings are already priced in to the markets, I don’t know what will trigger the stock market higher”.
Here’s the reality. Trying to “guess” what’s priced-in and what isn’t priced-in is nothing more than guessing. It’s a 50-50 bet. In other words, trying to “guess” what’s priced-in is a waste of time because nobody knows.
In reality, the market doesn’t care what’s priced in. The market cares about facts. Are corporate earnings going up or down.
They say that “the market discounts the future”. This isn’t entirely true. The market discounts the near-future, but it doesn’t discount the distant-future.
BS #2: “earnings growth can’t get better than this”.
Financial “experts” care too much about the rate of earnings growth. For example, Q1 2018 earnings growth was probably as high as earnings growth will be in this economic expansion. They say “it’s all downhill from here”.
That is misleading, plain and simple. The stock market doesn’t peak when the rate of earnings growth peaks. We demonstrated in this market study that the stock market doesn’t care about the rate of earnings growth. For example, the rate of earnings growth in this economic expansion peaked in Q3 2010 (34% year-over-year earnings growth). Earnings growth has slowed down since then. Meanwhile, the stock market has soared from Q3 2010 – present!
Do you know why the stock market doesn’t care about the rate of earnings growth? Because it tells you NOTHING about what earnings will be in the distant future. Here’s a simple example.
Let’s assume that earnings growth will never be higher than it is today (at 20%). Then earnings growth falls, and stabilizes at 10%. Corporate earnings continue to grow for the next 6 years. Even though the rate of growth has fallen, corporate earnings will be 77% higher in 6 years than it is today.
As you see, corporate earnings still trend higher, but just at a slower pace. The trend matters. The rate doesn’t.
BS #3: if the stock market doesn’t go up during “strong” earnings releases, it must be a bearish sign
I’ve seen this many times. Earnings season is very strong and most companies beat their earnings expectations. However, the stock market barely goes up during those 2 weeks when earnings are released. Then you hear the chorus of “this is a sign that the stock market will crash! If strong earnings can’t push the stock market up, what can?”
Here’s the fact. The stock market’s short term reaction to earnings season is mostly random. This short term “price action” tells you nothing about what the market will do in the medium-long term. Corporate earnings are meant to be used as a medium-long term indicator for predicting the stock market. It’s not meant to be used as a short term indicator.
If corporate earnings are going up, it means that the stock market will probably go up in the medium-long term. However, the stock market’s reaction to corporate earnings in the short term is random.
Corporate earnings today: Q2 2018 earnings season will be strong.
Q2 2018 earnings season is just around the corner. Earnings growth is expected to be very high (partially due to Trump’s tax cut, which boosts after-tax corporate earnings).
The S&P 500 companies’ earnings are expected to grow 20% year-over-year in Q2 2018. This is a very high rate of growth.
Once again, earnings and revenues growth is expected to be strongest in the commodities sectors (energy and materials) and the tech sector. The energy sector is doing well because oil is up year-over-year. But more importantly, the massive tech sector is crushing it because tech companies are invading every single industry (think about how much Facebook, Google, and Amazon are growing).
Earnings growth will probably fall in the next few quarters because the comparison becomes harder (the base earnings will be post-tax cut earnings). However, falling earnings growth is not a medium-long term bearish sign for the stock market unless corporate earnings growth becomes negative.
Corporate earnings growth will only become negative if the economy goes into a recession or oil crashes:
- Oil is unlikely to crash right now. The 2014-2016 oil crash was due to a massive excess of supply in oil.
- The economy will not enter into a recession in 2018. The economy doesn’t move as fast as the stock market. It moves more slowly. The economy doesn’t go from being very strong (i.e. right now) to a recession in the blink of an eye. Leading economic indicators point to continued growth in the economy.
12 month forward earnings will probably continue to grow throughout 2018 because a recession in 2018 is extremely unlikely. The rate of growth will slow down, but the key point is that forward earnings will grow.
This is medium-long term bullish for the stock market. 12 month forward earnings and the stock market move in the same direction in the medium-long term. With 12 month forward earnings moving higher, the stock market will eventually trend higher in the next few months as well.
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