Markets

Stocks may be rallying to records, but the earnings outlook is darkening

Key Points
  • The S&P 500 forward earnings year-over-year growth has slowed to less than 1% from a cycle peak of 23% just 14 months ago, UBS says.
  • Declining earnings expectations don't bode well for stocks as the last six times in the past 35 years have all seen compression in stock valuation and declines in the S&P 500, the bank says.
  • "There is no debate on S&P 500 forward earnings: a contraction appears imminent," says UBS equity strategist Francois Trahan. "An actual contraction in forward earnings usually spells a difficult backdrop for the overall equity market."
Traders react after the closing bell at the New York Stock Exchange (NYSE) on August 5, 2019 at Wall Street in New York City.
Johannes Eisele | AFP | Getty Images

Underneath the record-setting rally lies a worrisome earnings trend that is "uncommon and rarely good" for the stock market, UBS warned.

S&P 500 companies now expect to grow their earnings by less than 1% year over year, compared with a 23% growth rate just 14 months ago, the bank pointed out. Historically, declining earnings expectations didn't bode well for stocks as the last six times in the past 35 years have all seen compression in stock valuation and declines in the S&P 500, UBS said.

"There is no debate on S&P 500 forward earnings: a contraction appears imminent," UBS equity strategist Francois Trahan said in a note Tuesday. "An actual contraction in forward earnings usually spells a difficult backdrop for the overall equity market."

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The Dow Jones Industrial Average hit another record close Tuesday, while the rally in the S&P 500 seemed to have taken a pause with the index little changed in the session. Earnings for the S&P 500 are expected to decline by 3.1% for the third quarter, after growing by more than 3% in the second quarter, according to data from Refinitiv.

While the corporate earnings season has largely been better than expected as 75% of the S&P 500 companies that have reported topped analyst expectations, nearly a third of the companies, or 164, are now expecting lower earnings, compared with only 68 of them at the beginning of the year, the UBS strategist said.

"The breadth in expectations is equally troubling," Trahan said. "The most troubling part of all this is that it appears unlikely that the earnings picture will improve anytime soon."

When forward earnings declined in the fourth quarter of 2018, the market suffered a brutal correction with the Dow and the S&P 500 experiencing their worst December since the Great Depression.

"They eventually rebounded but the correction, however short-lived, was severe," Trahan said.