It has been a while since investors greeted what’s expected to be a strong earnings seasons with such disdain.
Earnings for S&P 500 companies are expected to grow 17% over the next 12 months, according to FactSet. Yet, valuations that investors are attaching to these earnings have dropped over the past few months, largely due to falling stock prices.
The 12-month forward price-to-earnings ratio has dropped 13% from 18.5 to 16 since late January when the S&P 500 SPX, -0.29% last hit a record, according to FactSet.
The price-to-earnings ratio is often viewed as a barometer of investor confidence. But even with the recent drop in PE ratios, valuations are still above long-term averages.
“It is still early in the earnings season, and as we hear from the CEOs we will find out if the market will refocus on fundamentals and away from the macro news,” said Jill Carey Hall, U.S. equity strategist at Bank of America Merrill Lynch.
Earnings season unofficially kicked off over the last week. On Friday, major banks JPMorgan Chase, Citibank and Wells Fargo reported earnings that were mostly in line or above expectations, yet, their share prices fell sharply, between 2% and 3%.
The performance helped drag down major indexes, with the S&P 500, Dow DJIA, -0.50% and Nasdaq Composite COMP, -0.47% all ending slightly lower. The indexes scored gains for the week, however, with the S&P 500 up 2%, the Dow up 1.8% and the Nasdaq gaining 2.8%.
“During the last earnings seasons, investors didn’t reward companies that were beating forecasts much and we believe that was due to very stretched valuations,” Hall said.
“In fact, we also saw considerable market volatility, even though both earnings and revisions to future earnings were positive. We wouldn’t be surprised to see the same thing repeat during this earnings season,” she said.
Another reason why markets aren’t rallying in the face of stellar earnings is the belief that earnings growth may have peaked.
“First-quarter results are old news, investors have known it was going to be great. But the worry among investors is that we have reached peak earnings and 2019 growth will start to slow,” said Mitchell O. Goldberg, president at ClientFirst Strategy Inc.
“Higher earnings will make valuations look better, but that is countered with rising bond yields and the end result is flat markets,” he said.
Long-dated Treasury yields have been rising since last year, but the 10-year Treasury yield TMUBMUSD10Y, -0.52% remains below 3%. Short-dated bond yields, more sensitive to Fed policy, are rising at a faster pace. At 2.3%, the 2-year Treasury yield TMUBMUSD02Y, -0.34% is at its highest level since 2008.
Hall, however, isn’t worried about slower earnings growth.
“Decelerating earnings growth, which will begin in the second half of this year, is widely expected. What would be worrying is to see a shift in outlooks due to trade disputes or rising inflation,” Hall said.
Markets, however, seemingly have a knack for spotting trouble before most investors.
Over the next three weeks, 341, or roughly two thirds, of S&P 500 companies will report earnings. In the week ahead, 56 companies are due to report, among them Johnson & Johnson JNJ, +0.15% Procter & Gamble Co PG, +0.75% IBM Corp. IBM, -0.86% and Netflix Inc. NFLX, +0.78%
On the economic calendar, retail sales are due on Monday, while housing starts and industrial production numbers will be released on Tuesday.
Several Fed officials are scheduled to speak in the week ahead, including San Francisco Federal Reserve Bank President John Williams, Chicago Federal Reserve Bank President Charles Evans and Philadelphia Federal Reserve Bank President Patrick Harker.
