On the bull market villains list, it’s public enemy No. 1: peak earnings. At what point does the profit bubble pop? Ever since Caterpillar mentioned a “high water mark” in growth, Wall Street has been on alert.
To date, the worries have been unfounded. Earnings soared 24 percent in the first quarter and did it again in the second. And while nothing is likely to prevent another blowout quarter in the third, one trend bears watching: the rate at which executives are guiding down forecasts.
Led by high-profile warnings from Netflix and Applied Materials, the number of S&P 500 companies saying profits will trail analyst estimates outnumbered those saying they will beat them by a ratio of 8-1 in the third quarter. That’s the most in Bloomberg data going back to 2010.
Several conclusions are possible, among them that analysts — who saw their predictions trounced at record rates in the first half — grew tired of being wrong and lifted estimates to unrealistic heights. Or, it could be that companies are making room for the quarterly ritual in which they beat every forecast by a penny.
Still, that happens all the time, without being occasion for this quarter’s lopsided guidance. For skeptics looking for evidence income growth is peaking, a more ominous takeaway is forming. It comes at a time when everything from rising costs to weakening overseas demand threaten to dampen growth, according to Tobias Levkovich, Citigroup’s chief U.S. equity strategist.
“Given ebullient investor sentiment, we do not think there is much room for companies to disappoint without taking a hefty toll on share prices,” he wrote in a note.
Companies are expected to earn $42.11 a share in the June-September period, a quarterly record. Yet with valuations elevated, the margin of error is getting thin.
The danger of an unexpected slowdown to the market was showcased on April 24, when Caterpillar signaled the first quarter might be as good as it gets. Shares of machinery giant tumbled 6.2 percent, sparking a decline in the broad market.
“Strong earnings have been the most important factor that has enabled the stock market to ignore the headwinds it has faced this year,” said Matt Maley, an equity strategist at Miller Tabak & Co. “If the projection for future earnings suddenly become less bullish, it could/should be enough to upset the balance between the bullish & bearish macro factors that are facing the markets right now.”
Wang writes for Bloomberg.