Strong earnings allay fears over trade and growth—for now

Companies like Alphabet and Twitter are beating expectations, but investors are pessimistic about the rest of the year.

  • By Michael Wursthorn,
  • The Wall Street Journal
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Corporate profits are proving to be more resilient than expected in the second quarter, nudging the stock market higher this month and distracting from anxieties about trade and economic growth.

Of the 221 S&P 500 companies that have reported earnings through Friday, 170 have surprised investors with better-than-expected results, according to FactSet. Technology giants Alphabet Inc. (GOOG) and Twitter Inc. (TWTR) both topped expectations, sending shares up 9.6% and 8.9%, respectively, on Friday. Coca-Cola Co. (KO) and United Parcel Services Inc. (UPS) also jumped after reporting results last week.

Average earnings among S&P 500 companies that have reported are up 0.7% from a year earlier, according to FactSet. That has helped improve analysts’ forecasts for earnings to a 2.6% contraction for the quarter, better than the more than 3% pullback they had been predicting last week.

“The notion of a widespread economic weakness seemed plausible just a few weeks ago,” said Ed Keon, chief investment strategist at QMA LLC. “But in the last week or so you got a pretty good picture of the earnings season, suggesting those fears are overblown. It’s a hopeful sign.”

Earnings reports surprising to the upside are fairly common because analysts tend to be conservative with their estimates. Still, money managers say the latest round of results quelled some of their concerns that corporate profits were rapidly shrinking amid a faltering U.S. economy. More than 80 companies had warned ahead of the reporting season that earnings could be weaker than expected, helping to temper expectations, analysts said.

The S&P 500 (.SPX) has risen 2.9% so far in July, extending its gain this year to 21%, largely driven by the expectation of an interest-rate cut from the Federal Reserve. The stock market’s two best months, January and June, coincided with some of the strongest signals from Chairman Jerome Powell that the central bank will cut interest rates this year. Data from CME Group showed investors are betting on a 100% probability that the Fed will cut rates at its meeting this week.

Still, earnings gains in the latest quarter have done little to lift investors’ enthusiasm about where the stock market goes from here. And for manufacturers like Caterpillar Inc. (CAT), import tariffs and trade tensions continue to weigh on outlooks. S&P 500 earnings are expected to rise just 1.7% over the full year, compared with the more than 3% analysts had penciled in last month.

The muted earnings outlook for the remainder of the year has contributed to a rise in pessimism among investors, analysts say. The share of individuals who say they expect U.S. stocks to fall or stay flat over the next six months has risen above those who are more bullish on equities, according to the American Association of Individual Investors’ latest survey.

“The ‘Powell put’ is driving the market higher, but the problem in the economy isn’t that rates are too high,” said Liz Ann Sonders, chief investment strategist at Charles Schwab Corp. “What ails us is a global manufacturing recession and business confidence being severely dented by a trade war.”

Industrial manufacturers are on pace to notch the second-biggest contraction in quarterly profits after materials stocks, with earnings projected to fall more than 12% from a year earlier, compared with expectations of a less than 2% pullback earlier this month, according to FactSet.

Caterpillar was a major contributor to that shift after the maker of bulldozers and excavators missed analysts’ earnings estimates because of slowing machine sales in Asia and higher costs from U.S. tariffs on Chinese imports. Shares of Caterpillar fell more than 2% last week.

Meanwhile, technology and communication companies reporting so far have mostly surprised investors to the upside, sending shares of both sectors up more than 5% each this month. Excluding a record-setting fine, Facebook topped analysts’ expectations for earnings and revenue, as did Google parent Alphabet.

But those latest gains have pushed stocks toward their richest valuations of the year, alarming some investors who fear the market doesn’t have much juice left to climb higher in 2019 after the S&P 500 posted its best first half of a year since 1997.

As of Friday, the S&P 500 traded at 17 times its earnings over the next 12 months, its highest level since late September, just before the stock market’s fourth-quarter selloff. That is above the 10-year average of nearly 15 times, according to FactSet, but well below the valuations of the dot-com era.

Alan Adelman, a senior fund manager at Frost Investment Advisors LLC, says current valuations include interest rates coming down and expectations of a trade resolution between the U.S. and China. If either of those don’t pan out, stock prices will need to be readjusted, he said. There is also some pricing in of a fourth-quarter bounceback in corporate profits, with earnings projected to climb 4.8% from a year earlier after declining nearly 2% in the third quarter, according to FactSet.

“We’re in the late stages of an economic expansion. Things can only go on for so long,” said Mr. Adelman, who has been focusing on investing in high-quality stocks that have relatively stable earnings and offer hefty dividends that exceed U.S. Treasury yields. “We have to be realistic. A lot of the positive news in the market is already baked in.”

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