Stocks are on the expensive side. The "Trump Trade" is on hold. And the early-year equity rally has stalled. That's why Wall Street says strong profit results from corporate America in the coming weeks is what it will take to revive the stock market's upside momentum.
It's now up to U.S. companies to deliver. They must top investors' high hopes for first-quarter earnings growth and help undo some of the negative sentiment that's held the market back recently, says John Stoltzfus, chief investment strategist at Oppenheimer. Since its March 1 record high the broad U.S. market has fallen about 2%.
"A good earnings season would likely justify higher prices for stocks in the months ahead," Stoltzfus says.
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Wall Street is hoping results from some of the nation's biggest banks this week will set a positive tone for the quarterly earnings season, which measures corporate profitability in the first three months of 2017. Expectations are high as stocks have stalled near record highs and investors are looking for reasons to justify the market's expensive valuations.
Analysts expect companies in the Standard & Poor's 500 stock index to post first-quarter earnings growth of 10%, which would mark the strongest growth since the third-quarter of 2014, according to earnings-tracker Thomson Reuters I/B/E/S. Profits continue to improve after a four-quarter stretch of negative profit growth ended in mid-2016. On Thursday, JPMorgan Chase, Wells Fargo and Citigroup will report profit and sales figures, giving investors fresh insight on the health of the economy and U.S. consumer, which account for roughly two-thirds of U.S. economic activity.
The good news? Most Wall Street pros expect earnings to come in better than analysts' current forecasts. Strategists at Wall Street firms Goldman Sachs, Bank of America Merrill Lynch and RBC Capital Markets all see the first-quarter earnings growth rate coming in closer to 13% to 14%. Earnings "beats" – or results that top expectations – are bullish for stocks.
Stocks and sectors of the market that will likely perform best are those capable of reporting stronger earnings growth than the overall market.
The January-thru-March profit rebound is due largely to a recovery in the energy sector, where profit growth of 600% is expected following losses a year ago. Oil companies benefited from a rebound in the price of a barrel of U.S.-produced crude, which averaged $52 in the first quarter, up more than 50% from $34 a year ago, Goldman Sachs says.
Other parts of the economy expected to post strong profits include financials (+15.2%), technology (+14.7%), home to names like Apple, Microsoft and Facebook, and the materials sector (+14.6%), which include chemical and paper companies,
Earnings season arrives at a time when U.S. economic growth is slowing and Wall Street is looking for signs the recovery remains intact. The Federal Reserve Bank of Atlanta recently cut its first-quarter GDP growth estimate to 0.6%, down from 2.1% growth in the final quarter of 2016. Investor sentiment has also been hurt by the inability of President Trump to get key parts of his economic agenda enacted. Tax reform -- one of the president's key promises, for instance, is still far off.
Here are some key things to watch this earnings season:
"Results from banks will set the tone for the earnings season," says Paul Hickey, co-founder at Bespoke Investment Group. Banks were a big beneficiary of the so-called "Trump Trade" after the November election. That's when investors began pricing in the benefits of less regulation, lower tax rates, higher interest rates and a stronger U.S. economy. But after rallying nearly 25% from Election Day to the end of 2016, the SPDR S&P Bank ETF has stalled and is down 3% in 2017. The stalled rally comes amid fears that Trump's agenda will be delayed, and worries related to the economy slowing down. Given banks' broad exposure to both consumers and businesses, they are viewed as a barometer of the economy.
"Banks are the grease of the economy," says Hickey. "We want to see more credit extended and more lending. It shows the economy is growing and it means more profits for the banks."
Double-digit quarterly profit growth for the S&P 500 sounds robust. But if you don't include the huge lift from energy companies, the rest of the sectors in the economy are growing profit at closer to 5%, says Patrick Adams, CEO and portfolio manager at PVG Asset Management. "Energy's (600% growth rate) distorts everything," says Adams. A 5% rise in profits, he says, is "not enough" to justify a market selling at 18 times this year's earnings, or about 20% above the long-term average. Nor is 5% growth fast enough to support an overpriced market in the event Trump's tax-cut plans don't materialize, he adds.
When it comes to stock performance in 2017, tech has led the way. The Technology Select Sector SPDR fund is up more than 9% this year, roughly double the gain of the broad market. If tech companies don't deliver the sizable earnings gains Wall Street expects, there's a risk that stocks in the sector could lose their status as market leaders, Adams warns. "Tech profits have to be strong," he says. "A lot of investment dollars have gravitated there. The risk is the market leader stalls out."
What will CEOs say about the future of Trump's economic agenda? At the moment, not much of the potential earnings benefits that might result from Trump's proposals to reduce corporate taxes, cut down on regulations and spend heavily on infrastructure are incorporated into Wall Street earnings estimates. But hopes for these growth-focused moves are already reflected in stock prices. Watch what CEOs say about their companies' future growth outlook under Trump. "If they don't talk up better business, that's a worry," says Bespoke's Hickey.