Peak earnings may arrive sooner than expected

  • The Fed outlook on gross domestic product after the FOMC meeting this week was positive.
  • But investors would be wise to keep their eyes on the GDPNow tracker.
  • It may explain the recent stock market volatility by answering the question: Is this peak earnings?

Weighing the good news versus the bad news issuing from the economy is one of the most critical things investors do, but human biases get in the way. That's a simple way of saying that people believe what they believe, even in the face of contradictions.

We have a massive jump in stock buybacks, courtesy of the tax law that was passed last December. Corporate earnings continue to come in stronger than expected. The labor market is healthy, consumer confidence is high and investors added a record amount of money to U.S. stock funds over the past week.

Philipp Guelland | Getty Images

It's hard to envision a slowdown in global economic growth on the horizon unless we get into a trade war with China. That could happen, but the current betting on Wall Street is that cooler heads will prevail. With this good news at investors' backs, it's understandable to be a bull, but investors also need to ask: Could peak earnings be coming sooner than expected?

There are some powerfully negative reads out there in the economy as well. Recently reported automobile sales and retail sales are weaker than expected. Mortgage refinancing plunged to a decade low due to rising rates. The tough tariff talk is getting nastier. Investors are uneasy over President Donald Trump's cabinet turnover because it can result in inconsistencies in fiscal and geopolitical policy. The mergers and acquisitions space caught a chill, first via the AT&T/Time Warner deal running into regulatory resistance and more recently the Broadcom/Qualcomm deal getting blocked. And to top it all off, Toys R Us shuttering will add a sizable chunk of vacant retail space to the ongoing retail landscape apocalypse.

Contradictions can come so quickly amid a volatile market that it's hard to keep track of them. Doesn't anyone remember that the February government employment report released on March 9 sent the Dow Jones Industrial Average soaring 440 points because wages were less than expected? It was an unexpected rise in wages, reported by the government on February 2, which sparked the stock market sell-off last month. That surge in U.S. stock fund flows last week came after a few weeks of huge outflows, and the strong labor market could be too strong if wages resume a rising path too fast.

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If only there were a way to pinpoint a running summary of available economic statistics that could make sense of it all in just one statistic, one that could provide us with an up-to-the-minute estimate for real U.S. gross domestic product growth.

There is.

The GDPNow figure, via the Federal Reserve Bank of Atlanta, provides a running estimate of real GDP growth based on available data for the current measured quarter. I'll provide the link below so you can follow along going forward. An observation I'd like to make is that the stats in the front of the quarter have enormous sway over the GDPNow estimate because the data set is limited to just one or two stats. If the first stat of the quarter is strong, then the GDPNow will reflect that strong figure. As the quarter goes by and more stats are input into the model, the more it moderates. If the GDPNow starts the quarter with a high number and sinks into the end of the quarter, then stats are coming in weaker, which may indicate a weakening economy.

The first quarter started out strong with a GDPNow print at a high level of 5.4 percent. But after nearly a full quarter's worth of economic statistics, it is now running at a dismal 1.8 percent.

One thing missing from that 1.8 percent figure is the earnings outlook for stocks. Companies have been exceptional at generating strong earnings growth in a lightweight GDP environment ever since the end of the Great Recession. Fourth-quarter 2017 showed one of the best earnings growth rates we've seen since then. Now that the recently enacted tax laws have come to pass, it's pretty much a widely accepted forecast that earnings should do well into the end of this year and remain at that level into 2019.

That's the good news. But that's also the bad news.

A black swan too obvious to see

Stocks don't just trade up on earnings; they trade up on the growth rate of earnings, which in some ways is more important than the actual level of earnings. Without another major push by the government to give the economy another major spending boost or tax cut (there has been talk of a second round of tax cuts by Trump and GOP leaders on Capitol Hill), and without a really strong rebound in GDP outlook, investors should be more inclined to consider whether we have reached peak earnings and act based on the need to cut back on stocks.

In other words, as the corporate tax-cut benefits roll off at the end of 2018 and we get into next year's earnings outlook, investors might just have to accept that the earnings outlook for the rest of this year is as good as it gets.

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As far as the weak GDPNow estimate for Q1, investors could take some amount of solace in the fact that "first-quarter blues" occurred in 2016 and 2017, yet both years saw a rebound in GDP as the year moved forward. Maybe this year is going to be a three-peat.

The Fed thinks so (improving GDP), according to its FOMC meeting statements this week. Its forecast for unemployment rate dives into the mid-3 percent range and raises its inflation forecast. Regardless, it is now prevailing wisdom that a wage boost is coming. That's not good for earnings. Maybe the ever-elusive black swan, something unforeseen, which ends this bull market is that the economy is just running out of steam and it's too obvious to see it.

For now, the betting is that GDP will accelerate as 2018 goes on. We'll see soon enough. I know amid all the contradictory signals from the economy, it's the one I will be watching.

By Mitch Goldberg, president of investment advisory firm ClientFirst Strategy

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