Looking at the chart, the bars represent the difference between the earnings growth reported by companies in the S&P 500 for a particular quarter and the expectations held for earnings growth at the start of the quarter. One can think of the bars as indicative of an earnings surprise. As highlighted for the current quarter, not only are earnings falling well short of expectations but also the magnitude of the shortfall is approaching what was last seen in the early part of the decade.
Because of news flow or the guidance that companies give, the expectations held by the consensus at the end of a quarter will differ from the expectations held at the start of the quarter. As it happens, they’ve usually been lower, as was the case this time round. The difference between what companies report and these latter expectations is also indicative of an earnings surprise and, typically, the earnings reported end up beating these lower expectations. Not so this time!
Over half of the companies in the S&P 500 has reported for the third quarter and two thirds of them have beaten expectations. However, in aggregate, the earnings for the S&P 500 are still falling short of the expectations held by analysts at the start of the quarter and falling short of the downwardly revised expectations held by them at the time companies started reporting. To repeat, earnings are coming in significantly worse than expected for the first time in a long while and that’s not good news for equity markets.
Also shown in the chart is the trend of US GDP growth (solid line). It’s interesting to observe how the magnitude of the earnings surprises - the bars - correlates with the momentum underlying GDP growth. This is not to say that GDP growth ‘causes’ earnings surprises but the association between the two is evident. A loss of economic momentum spells a loss of momentum in earnings growth and, right now, the US economy is losing momentum, which means that analysts will have to lower their earnings estimates for the final quarter of this year and for 2008.
Slower growth in profitability means slower growth of investment and jobs. US job growth is already weakening so the growth of consumer spending will weaken as a result. Weaker job growth will also put more pressure on a housing market that is showing no sign of stabilizing. None of this is good news for default risk, which lay at the heart of this summer’s market turbulence and which led to the clamming up of the money markets.
So what this points to is another cut in US interest rates next week, perhaps not another 50 ‘bips’ but 25 at least in both the discount rate and the Funds rate. And who knows, maybe the Fed will go for 50 ‘bips’.
Volatility in the equity market, as measured say by the Chicago Board of Trade’s volatility index for the S&P 500 - the CBOE VIX - has been on the rise this year but so has the underlying trend of the major equity markets. An increase in volatility may force investors to become more ‘risk averse’ than they might be other wise and it may restrain the animal spirits that invigorate a bull market, but it needn’t bring a bull market to an end. Fundamentals do that!
Are the fundamentals bad? The US economy is weakening, which is why the Fed is cutting rates. It’s also why earnings growth is slowing faster than expected but then the financials - not just the banks - have taken a big hit. The news flow in various sectors, e.g., consumer discretionary, industrials, energy, materials and even in some areas of the technology is less good than before. Rising oil prices, now working their way towards US$100 a barrel, aren’t good.
On the other hand, around a third of the sales for the S&P 500 is derived outside the US - much of it in faster growing regions of the global economy. In addition, while the weak dollar hurts the UK exporters, overseas earners and sterling investors, it enhances the competitive position of US companies at home and abroad and that’s good for earnings.
Fundamentals aren’t great but they’re not really all that bad and, with the Fed cutting rates and valuations still satisfactory even allowing for earnings downgrades, I think the bull market still has legs. We’ll just have to put up with the volatility.