We are more than a quarter through earnings season, with another 120 companies reporting this week. On the surface, the news could not be better: Earnings are growing faster than anyone anticipated even a few months ago, even heading into the first quarter of 2018.
But we may finally be seeing a visible catalyst for a pullback. As the 10-year Treasury yield has passed 2.7 percent, traders have been getting nervous. Rates moved up 5 basis points over the weekend on not much news.
It's not just the level of rates, it's also the velocity of the moves. The market has shown it does not react positively if rates move too quickly.
Strategists have taken note: Stifel, in a note this morning, said "We see a 5+ percent S&P 500 correction in Q1 2018 as yields rise abruptly to reflect growth as well as inflation, and central banks pursue a more coordinated and multi-lateral exit from increasingly risky rate suppression."
This means that in a week filled with potentially market-moving news (State of the Union address, the biggest earnings week of the quarter, the December jobs report) the single biggest most likely market-moving news will come from the Fed meeting on Wednesday.
With rates moving this fast, it wouldn't take much to move the markets, and convince traders that we are in for at least four rates hikes this year, not three — and possibly more.
"If the FOMC acknowledges the U.S. economy continues to gain momentum as the labor market slack shrinks further as well as comment that market-based measures of inflation expectations, (i.e. 10Y TIPS breakeven rate) is moving higher, that will further fuel bond bears and support in their call for four rate hikes instead of three," Adrian Miller, an independent bond analyst, wrote to me this morning.
Traders are already looking at signs inflation might be picking up. They include a pickup in wages (Goldman's Jan Hatzius expects average hourly earnings to grow 3 percent to 3.5 percent in 2018), better than expected economic numbers (the Citigroup Economic Surprise Index, a measure of how much economic forecasts are exceeding estimates, is near its highest level ever) and an 8 percent gain in the last month in the price of gold, a traditional hedge against inflation. That is a near-18 month high.
So, why isn't the market reacting even more to these concerns? After all, everyone knows the biggest killers of market rallies have been recessions and sudden spikes in interest rates.
The answer is in the tidal wave of higher earnings. More companies are 1) beating estimates, 2) beating by wider margins, and 3) seeing estimates continue to rise into the first quarter.
Let's start with the companies beating estimates. According to Thomson Reuters, 79.7 percent of companies reporting so far are beating earnings estimates in the fourth quarter. That is way above the historic trend of 64 percent. And 82 percent are beating revenue estimates, way above the 60 percent that historically beat expectations.
Another important trend: They are beating by wider margins than normal. Take today's earnings news — Seagate Technology and Lockheed Martin. Seagate reported earnings 9 percent above expectations, while Lockheed Martin reported earnings about 6 percent above expectations.
So far, earnings have been 4.6 percent above expectations, versus a long-term historical norm of 3.1 percent.
Finally, the numbers are continuing to rise in the first quarter.
Q1 2018 S&P 500 Earnings
Earnings: up 16.7 percent
Revenue: up 7.3 percent
Source: Thomson Reuters
These numbers traditionally go up through the quarter, and then come down in the final weeks as analysts get greater clarity. But that did not happen in the fourth quarter. The numbers rose into the end of the year, and there is a good chance they will not drop appreciably in this quarter.
With numbers like these, it's not hard to understand why traders are reluctant to dump such a hot hand.