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When earnings look this great, it's a really bad time to invest

CNBC logo CNBC 5/17/2018 Jeff Cox
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To the naked eye, corporate profits are in a state of bliss. To history, the perspective is quite a bit different.

Investors have been puzzling over the strange earnings-stocks disconnect this year. With profits at a seven-and-half year high in the first quarter, it would be logical to assume that Wall Street would be roaring and the bull market would be entering a new, even more prosperous phase.

But as impressive bottom-line (and top-line for that matter) numbers continue to roll through, equities are stuck in a funk. The S&P 500 has gained less than 2 percent in price for the year, a far cry from the 25 percent jump in year-over-profits for the index.

While that seems odd on the surface, a look back in time says that's pretty much how it works this late in the economic cycle.

"There's a contrarian story to tell when earnings growth joins the > 20% club," Liz Ann Sonders, chief investment strategist at Charles Schwab, said in a recent market note. Investors, she said, should remember that "the stock market has a keen ability to sniff out inflection points in advance."

"Yes, 20%-plus earnings growth is good news in an absolute sense, but it also likely represents a rate fairly close to the ultimate peak growth rate — beyond which the growth rate will inevitably slow," Sonders added.

Indeed, the market has been here before, and the results have been about the same.

In fact, earnings growth of more than 20 percent has been the worst time for stock market performance, other than the rare instances when profits have declined by more than 25 percent, according to data going back to 1927:

The sheer numbers for earnings so far are remarkable.

With all but a few big names remaining, 78 percent of S&P 500 companies have beaten Wall Street estimates, which would be the highest level since FactSet started tracking the measure in 2008.

Earnings growth heading into this week was 24.9 percent, the best since the third quarter of 2010. Ten of the 11 sectors in the index have seen higher growth rates than what was projected.

Finally, the rest of the year looks strong as well. FactSet projects quarterly growth of 18.8 percent, 20.9 percent and 16.5 percent for the respective three quarters ahead, with full-year profit gains coming in at 19.2 percent on 7.2 percent revenue growth.

The reasons for the lackluster market reaction have been well-documented: Fears that this may well be the peak, along with concerns that rising inflation will prompt a strong interest rate response from the Fed which could slow what is expected to be above-trend economic growth ahead.

Further, Sonders pointed out that while falling price-to-earnings multiples may make the market look cheaper, that's really just a natural reaction to inflation expectations.

"In simple terms, this is a function of earnings being less valuable when inflation is higher," she said.

To be sure, neither Sonders nor many other market veterans are predicting that the weak reaction to earnings necessarily foreshadows a recession and an end to the bull market. Instead, the sluggish first-quarter market gains simply could become the norm.

John Lynch, chief investment strategist at LPL Financial, points out that this is the 36th consecutive quarter that earnings have beaten Wall Street estimates, and he expects the momentum to continue. Absent a recession, Lynch sees the bull market continuing.

"We expect strong earnings growth to drive a double-digit return for the S&P 500 in 2018, though as we have seen recently, those gains may come with higher volatility," he said.

That's a familiar sentiment on the Street.

"Earnings growth has been exceptionally strong; but much of the latest acceleration is already in the books and partly a function of one-time factors," Sonders said. "This does not necessarily signal the end of the bull market, but it does suggest the bar has been set quite high, which could lead to both disappointments and bouts of volatility as markets look out toward a slower growth rate and deteriorating profit margins."

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