Record Stock Market Levels Mask Earnings Reality
The S&P 500, Nasdaq, Dow Jones Industrial Average, and TSX are all trading at, or near, record stock market levels. On the surface, how can this be anything but good news? But if you dig into the data even a little bit, you’ll see that North American companies are struggling with the ongoing trade war between the U.S. and China. In fact, Main Street is doing a lot worse than what Wall Street is saying. Earnings for the second quarter are expected to decline and the third quarter doesn’t look any better.
Stocks are at record levels and most investors couldn’t be happier. The problem is, those record stock market levels are masking serious issues on Wall Street. Thanks to ongoing tensions between the U.S. and China, North American equities are not expecting to report earnings growth in the second or third quarter. In fact, it’s tough to find a company that expects to report quarter-over-quarter earnings growth.
According to the most recent data, the average projected earnings decline for S&P 500-listed companies in the second quarter is -2.6%. If this holds, it will be the first time the S&P 500 has reported consecutive year-over-year declines since the first two quarters of 2016. It will also be the biggest year-over-year decline in earnings since the second quarter of 2016 (-3.2%).1
What about the third quarter? Analysts expect the downward pressure on earnings to continue into the third quarter. Right now, the earnings decline for the third quarter stands at -0.3%. That might not sound like much, but at the start of the year, Wall Street was projecting third quarter earnings growth of 3.4%.
Corporate American may have avoided an earnings recession in the first quarter, rising a limp 0.6%, but it doesn’t look like it’s going to be able to do that in the second and third quarter. Why is that, when much of Bay Street and Wall Street are reporting solid revenue growth?
The problem with a trade war is not so much what it does to revenue, but to earnings. Decades of free trade has helped strengthen the bottom lines of corporate Canada and the U.S. Yes, increased profitability can be attributed, in part, to cheap money, cost cutting, and innovation, but most of it is a result of free trade and lower taxes.
A trade war with China won’t decimate the U.S. economy, sales to China actually make up a very small part of the U.S. economy; around $130 billion of U.S. exports from an annual $19 trillion economy. But it will hit profits.
Despite the weak earnings outlook, stocks could still trade higher. That’s because investors believe the Federal Reserve will cut its key lending rates in the coming months and will see stocks as providing a better return.
Unfortunately, a record stock market fuelled by artificially low interest rates and devoid of earnings growth, increases the risk of a stock market correction and poses a significant risk to the Canadian and U.S. economies.
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- “S&P 500 Now Projected To Report A Year-Over-Year Decline In Earnings In Q3 2019,” Factset website, June 21, 2019; https://insight.factset.com/sp-500-now-projected-to-report-a-year-over-year-decline-in-earnings-in-q3-2019.
Photo credit: iStock.com/Dilok Klaisataporn
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