After an uncommonly strong three-week rally, the stock market is up 10 percent from the harrowing 20-month low it reached in a nearly unprecedented December meltdown. But the index is still 11 percent below its September record high and down 6 percent from a year ago.
So what's now priced into the market, as earnings reports start to pepper the tape? It's a crucial question with a pretty wide range of answers.
(Futures pointed to a decline on Monday as earnings season kicks into full swing with Citigroup saying revenue missed expectations)
Starting from an undisputed point: Some degree of economic and profit-growth slowing has been factored into share prices at this point. The S&P 500's multiple on the coming 12 months' forecast earnings is now just above 15, down from above 18 a year ago — when the market was aggressively pricing in the 20-percent profit gains of 2018, much of it thanks to the corporate tax cut.
The market briefly flashed "cheap" near the December low at just under 14-times forward earnings, but quickly bounced from there to a more neutral valuation relative to its 10-year trend.
Here's another look at the S&P 500 tracked against the earnings trend, showing that brief drop to what was arguably an overshoot below fundamental expectations:
Yet those earnings expectations are being cut at a fairly brisk clip. Estimates for the fourth quarter results about to be reported in coming weeks have come down by five percentage points in the past three months.
Deutsche Bank strategist Binky Chadha says this pattern should continue: "Historically, large cuts in a quarter have tended to be followed by further cuts in forward estimates;, they have typically taken time to play out. Earnings revisions are also tightly correlated to our US data surprise index which recently turned negative for the first time in two-and-a-half years and the typical pattern suggests more downside before a bottom, also suggesting earnings downgrades will continue."
Yet he goes on to say that stocks can continue their recovery against this backdrop, citing other recent periods, in 2012 and 2016, when earnings expectations continued to slip while stocks edged higher following large declines.
Chadha argues that the market is already priced for a 10 percent slide in 2019 earnings, though that calculation relies on several assumptions about what a "fair" multiple is given current inflation, interest rate and cyclical factors.
RBC Capital Markets strategist Lori Calvasina says the drop in valuation in the past year almost perfectly matches the typical historical multiple compression seen during a Fed tightening cycle. So perhaps if the Federal Reserve is indeed done raising rates for the foreseeable future — as the bond market is now betting — then maybe the pain in P/Es has largely been felt.
Still, valuation models might say the market has factored in softer profitability, but the process of numbers being sliced company by company, analyst by analyst, can take its toll on the market all the same.
Goldman Sachs strategist David Kostin this weekend flagged downside risk in S&P 500 earnings for this year to about $168, versus the current consensus above $171. This would amount to around 3 percent annual earnings growth.
As detailed here, Kostin argues: "With no nascent signs of slowing negative revisions, the strength of 4Q results and management commentary around the outlook for 2019 will take on heightened importance for whether earnings estimates (and returns) stabilize in the near term."
Credit market will also have plenty to say about whether equity valuations hold, improve or erode from here. Tighter financial conditions haven't been repealed by the somewhat gentler tone taken by Fed Chair Jerome Powell in recent weeks.
The spread between triple-B-rated corporate bonds and Treasuries — an important gauge of risk appetite and corporate liquidity - is just under two percentage points. That's up quite a bit from a year ago but not quite at alarmingly wide levels last seen in early 2016.
Yet the yield on triple-B debt is now 4.67 percent because Treasury yields are higher now are above where they've been since the stressed market of 2011, when the S&P traded much cheaper, at 13-times expected earnings.
Tying all these threads together, it seems the market is pricing in a more subdued but still favorable environment across several fronts. By no means is anything like a recession factored in.
But if earnings can grow around a mid-single digit percentage this year, and if the Fed stays in a prolonged pause, and if credit markets remain firm, and if the market finds no reason to begin aggressively pricing in a 2020 recession in coming quarters, then stocks have a path higher. The difference between a bull and bear for 2019 is whether this seems the most plausible outcome, or relies on too many "ifs."
This scenario would fit with earlier "mini-bear markets" featuring a peak-to-trough 19 percent drop that came from a "growth scare" and credit stress in such years as 1990, 1998 and 2011.
Those are the fundamental inputs. On the more tactical, psychological fronts, the recent evidence is somewhat encouraging, but also contingent.
The 10 percent rebound off the December low has been unusually broad and impressively persistent. Credit, oil and currency markets and volatility gauges have all reflected a rebuilding of risk appetites.
Technical analysts and those looking to marshal the evidence for a bullish stance keep citing a rare "breadth thrust" registered as the rally accelerated — a measure of how quickly the market rushes from extremely oversold to a "buy everything" stampede. The historical results six months after such readings have almost always shown positive returns above the long-term average.
True, often a "retest" of such a climactic low is needed in subsequent weeks or months. And the rally — fueled by an extreme buildup of investor pessimism cited here last week — has now carried right to a spot on the chart, the 2600 level on the S&P 500 — that is under universal scrutiny as the bottom of the busted 2018 range and an obvious, logical area for the market to stall or retreat.
Could be an interesting week.