Trader Talk

Halfway through earnings season, and the market likes what it sees

Market opens mixed, durable goods number weaker than expected

Stocks have rallied this week on a combination of lower geopolitical worries (French election), long-awaited tax cuts now in play and — perhaps most importantly — earnings guidance that has generally been better than anticipated.

I am talking about full-year earnings guidance, not just first-quarter earnings reports. That guidance has been strong so far, particularly in industrials. The largest names have not only beaten guidance, but they also raised full-year estimates, including: Caterpillar, 3M, Illinois Tool Works, Honeywell, Stanley Black & Decker, Dover, Sherwin Williams, Boeing and Rockwell Automation. Other big companies like General Electric and United Technologies reaffirmed their full-year guidance.

This is a HUGE relief to the markets. Traders have been concerned because the market is expensive by historic standards (better than 18 times 2017 earnings). Analysts have been modelling notable increases in earnings for the rest of the year, based not on the Trump tax cuts but on a synchronous global economic expansion:

S&P 500 Earnings (estimates)

Q1: up 11.8%
Q2: up 9.5%
Q3: up 9.3%
Q4: up 13.5%

Source: Thomson Reuters

These are big expectations! If corporations were to come out and play down the estimates in large numbers, the market would definitely take a hit. But due to the strong guidance, that is not happening.

Some are including unusually buoyant commentary on global business conditions, like this one from Caterpillar CEO Jim Umpleby: "There are encouraging signs, with promising quoting activity in many of the markets we serve and retail sales to users turning positive for both machines and Energy & Transportation for the first time in several years."

It's not just the U.S. Earnings are improving in Europe as well. The STOXX 600, the European equivalent of the S&P 500, saw earnings grow 12.9 percent in the fourth quarter. That follows a year of declining earnings. It's now expected to see earnings in the first quarter up 5.5 percent, with revenues of 5.7 percent, the strongest since the first quarter of 2012 when it was 6.7 percent.

Is all this really enough to keep stocks moving forward? Some don't think it is. UBS, in a report out last week, said "[W]e don't believe that 'earnings beats' will be sufficient to move all stocks higher this reporting season."

We've heard from financials and industrials, now big tech will report. We'll hear from Amazon, Google, Microsoft, and Intel on Thursday, and we will quickly find out if this trend continues.

When you think of the "risk factors" that move stocks, the recent trend has been toward lower risk:

  1. Geopolitical risk is lower due to the French election, though North Korea remains a major concern.
  2. Earnings guidance risk is somewhat lower now that numbers are coming in.
  3. The risk that the Trump tax cut agenda would fail, while still possible, is also somewhat lower now that at least a tax plan is in play.
  4. The risk that economic data will disappoint is still very high, but bulls insist that the data will improve in the coming quarters.
  5. The risk that the Fed will raise rates more aggressively than the markets anticipate has also declined, since they will wait for stronger data and for a clearer outline of the Trump agenda.

Put this all together, and you can see why the S&P 500 is just shy of an historic high.