Corporate Earnings: Finally Back to Growth?
Famous value investor Benjamin Graham once made the following observation regarding the stock market: “In the short run, the market is a voting machine but in the long run, it is a weighing machine.” What Graham refers to when he cites the market as a “weighing machine” is the influence of earnings (profits) over the long-term. Regardless of whether a stock goes up or down in the short-term, a stock’s price over the long-term is almost exclusively based upon how profitable that firm is.
Earnings, for better or worse, drive the long-term direction of the stock market. The U.S. stock market has remained relatively flat over the past two years because earnings have suffered. On a total return basis, the S&P 500 is up 6.6% year-to-date in 2016 and up only 1.38% in 2015.
Over the past year, we have been in what has been called an “earnings recession” here in the U.S. While we don’t know the outcome quite yet of Q3 2016 earnings, for the previous five quarters the S&P 500 has experienced earnings declines. These five consecutive declines mark the worst showing for U.S. companies since the subprime crisis of 2007-2009. What’s more, the S&P 500 has experienced six consecutive quarters of revenue declines.
Usually when corporate earnings suffer, this is a strong indicator of an economic recession. Happily, we are not likely facing a recession this time around. The culprit for the significant decline in profits is mostly attributable to the energy sector. The decline in corporate profits in the U.S. is not due to lower consumer spending or weaker demand, but from an exogenous shock to the economic system: massively lower oil prices.
It has been no secret that energy prices have plummeted in the past two years. WTI crude oil used to trade at over $100 per barrel, while today it trades at about $50 per barrel. This oil price decline has created fairly large earnings losses for U.S. energy companies, in turn weighing down the broader S&P 500 Index.
When accounting for the energy industry as a clear negative, a different picture of U.S. earnings growth emerges. According to Morgan Stanley, S&P 500 earnings in 2015 were actually positive by 6%, when the energy sector is excluded. This year, as oil prices climb from their trough below $30 per barrel to over $50, we see less of a drag from the energy sector. Accordingly, the broad S&P 500 Index is expected to return to earnings growth for the foreseeable future.
While the growth of the U.S. economy over the past five years has been relatively slow, the cumulative recovery from the subprime crisis is now nearly fully complete. Doomsday market analysts may be quite alarmed by the recent decline in earnings in the S&P 500, but the explanation (plummeting energy prices) is quite understandable and not indicative of bad economic times ahead. We welcome the U.S. markets to a probable return to earnings growth over the next several quarters.
The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. All performance referenced is historical and is no guarantee of future results. All indices are unmanaged and may not be invested into directly. The economic forecasts set forth may not develop as predicted. Because of their narrow focus, sector investing will be subject to greater volatility than investing more broadly across many sectors and companies. The Standard & Poor’s 500 Index is a capitalization weighted index of 500 stocks designed to measure performance of the broad domestic economy through changes in the aggregate market value of 500 stocks representing all major industries