If the stock market rally is going to continue the next couple of months, it will have to do so against an aggressively worsening profit backdrop.
The corporate earnings picture is ugly and getting uglier in a hurry, with companies expected to post an 8.3 percent decline in first-quarter profits from the same period a year ago. While history suggests that earnings season always ends up looking better at the end than it did at the beginning, if the current trend holds up it will be the worst period since the third quarter of 2009, according to FactSet.
At a time when the stock market has just recently erased its losses for the year and bounced out of correction mode, the worsening earnings picture presents a formidable headwind. After all, analysts at the beginning of 2016 actually had been projecting a modest 0.3 percent earnings increase.
That outlook has changed rapidly, triggering concern that the recent market uptick, featuring a gain in the S&P of nearly 7 percent over the past month, could fade amid renewed concerns over corporate America.
"One thing that probably slows us down in this move is certainly the realization that we don't have robust earnings growth," said Art Hogan, chief market strategist at Wunderlich Securities. "At some point we will come to an inflection point where that starts growing again. But that's not happening in this quarter."
Unlike previous quarters where the damage was confined largely to energy and, to a lesser extent, materials, the profit declines are widespread.
Just three of the S&P 500's 10 sectors are projected to show growth for the quarter, with telecommunications expected to climb 13.5 percent as the biggest gainer and discretionary next at 10.3 percent, according to FactSet. However, telecom is the smallest S&P 500 sector by market cap, making up just 2.8 percent of the index. Energy is tracking as the worst sector, with a 97 percent decline expected. The category comprises about 7 percent of the index, according to S&P Capital IQ.
The dimming profit picture likely will cause investors to re-evaluate positions at least in the near term, Hogan said. He sees the current rally based on investors recalibrating positions that were based a recession that didn't happen. Once those positions are covered, the rally could run out of steam.
"There is a credible possibility that we'll need to consolidate gains for a period of time," he said. "We can end the year higher than we are now, but i don't think we move considerably higher in the near term."
To be sure, investors are familiar with a climate of low corporate profits, a condition that has weighed on stock market prices for more than a year. In addition to this shaping up as the worst quarter since the financial crisis, it also will mark the fourth consecutive quarter of decline, something that FactSet said hasn't happened since the fourth quarter of 2008 through the third quarter of 2009.
Consequently, investors may well have the worst of the earnings news already priced into the market, said J.J. Kinahan, chief strategist at TD Ameritrade.
"Expectations are low. There's a participation trophy expectation thing going on," Kinahan said. "For most companies, all they have to do is beat that or a little better and it could be an OK earnings season."
Financials, technology and housing stocks will be the key, he added. Bank names are in an adjustment period now that the Fed appears to be on more of a dovish course on interest rates, while housing will provide a barometer for the consumer, he said.
Tech, and in particular information technology spending, will provide a glimpse at corporate attitudes about investment, he added.
"What may be more important are the forward-looking statements," Kinahan said. "Tech is almost like infrastructure. If they're not out spending money on tech, then we do have an issue that companies don't have confidence."