Market check-in: breakout or fakeout?

Less than a month after Brexit, U.S. stocks have set record highs and may be poised to climb higher.

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Anyone who’s ever tried to forecast a market top or bottom knows that waiting for a turn in the market’s fundamentals means missing out on its early momentum. It’s typically the turn in the rate of change that matters, because that’s where the market starts to inflect up or down. At major inflection points, especially bottoms, the market tends to fly when fundamentals shift from “more bad” to “less bad.”

With this in mind, I’m trying to find a narrative behind the market’s stealthy but decisive post-Brexit break-out to all-time highs. After closing at 2,000 on the Monday after Brexit (June 27), the S&P 500 closed at a record-high 2,175 less than a month later (July 22). At first, I thought this was a sugar rally, built on the promise of more easy money from the world’s central banks. But based on further research, it may be something more sustainable, or perhaps a combination of the two.

As I’ve been saying for quite a while, what this market needs in order to break out to new highs is earnings growth. But there’s been no earnings growth since 2014, causing the S&P 500 Index to be stuck in a relatively narrow trading range (1,810 to 2,130) for so long. I call it “bull market purgatory.”

In the absence of earnings, and with valuations at fair but full levels (18x trailing/17x forward P/Es), the market has primarily been fueled by changes in financial conditions. Such changes are mostly driven by the dollar, which is powered by the ebb and flow of the policy divergence between the U.S. Federal Reserve (the Fed)—which is tightening monetary policy—and the world’s other major central banks, which are in easing mode.

As a result, most market swings during the past 18 months can be explained by changes in the Fed’s policy guidance, or by changes in the market’s assessment of what the Fed will or won’t do. In other words, in the absence of earnings, every rally has been a sugar rally until this point, premised on the expectations of more easy money. In the meantime, earnings growth has slowed from about 7% year over year in 2014 to 0% in 2016.

A turn in the earnings cycle?

But what if the earnings cycle is starting to turn? With the stock market at all-time highs and valuations fair, the bar is set extremely low for the market to climb even higher. Any earnings growth at all, even a percent or two, could move the needle. Then before you know it, we could be looking at an S&P 500 of 2,300 to 2,400.

So now, with the market potentially breaking out, the question before us is whether the earnings cycle is indeed turning for the better. If so, we have fundamental justification for the rally. If not, this move may well be yet another failure at the top of this long-running trading range.

At first glance, the answer to whether earnings are turning appears to be “no”—the level and rate of change of trailing earnings per share (EPS) have not improved. Trailing operating earnings for the S&P 500 have been flat at around $116 to $118 per share,1 and the growth rate is around zero, where it has been for most of 2016. Forward earnings haven’t moved much either, with EPS estimates for the next 12 months at around $125. However, a look under the hood reveals a possible turn in the rate of change.

The estimated year-over-year growth in EPS chart shows the week-to-week progression of EPS growth estimates for each quarter over the past few years. These estimates typically start too high, and then drift lower and lower until the start of earnings season. Typically, the consensus growth estimate declines by about 800 basis points (bps), or eight percentage points, during the two quarters leading up to earnings season. But then earnings season starts and the majority of companies end up beating the estimates. By the time earnings season is over, the growth numbers have recovered by about 330 bps, on average.

Of course, like a game of musical chairs, these companies just guide lower for the upcoming quarter in lockstep with how much they beat estimates in the current quarter. So the same seasonal pattern continues quarter after quarter: Estimates start too high, then fall, and then recover.

So where’s the inflection point? With 2016’s second-quarter earnings season now under way, companies are mostly beating estimates (as usual), but this time the starting point of the earnings season is higher than it was in Q1. That’s new. If the normal seasonal progression repeats (where the start of the earnings season is the low point), we may have a reached a low point in the rate of change.

As the EPS growth chart shows, at the start of Q1 2016, the growth estimate was -10.1%, while the previous quarter’s estimate was -6.7%. Before that it was -6.6%, and before that it was -6.5%. In other words, there was a sequence of lower lows, in which both the level of earnings and the rate of change were falling. But now, at the beginning of the Q2 earnings season, the estimate is at -5.8%.

So, for the first time during this earnings cycle, we’re seeing a better rate of change than in the previous quarter. And if we add the typical 330 bps bounce, earnings growth should hypothetically be roughly -2.5% when the quarter ends in a few weeks. That’s still negative, meaning the level of earnings would still be declining. However, it would be significantly less bad than Q1, which ended at -7.0%.

In looking at the ending earnings growth rate over the past six quarters, there was a pattern of lower lows. Earnings growth in Q1 2015 was +0.5%, followed by -2.1% in Q2, -3.8% in Q3, -4.4% in Q4, and -7.0% in Q1 2016. But if the normal seasonal pattern holds, Q2 earnings could be a potentially higher low of -2.5%. So there you have it: a hint of a possible turn in the rate of change.

Quality vs. quantity

Even if we do have a turn, it doesn’t change the fact that the recent quality of earnings has left something to be desired. The only reason that EPS has been flat and not negative is due to “financial engineering.” Share buybacks continue to rise and currently make up more than 70% of the net income for S&P 500 companies.2 The slump in earnings has been a big driver of this trend, and it is those share buy- backs (as well as mergers & acquisitions) that are responsible for shrinking the availability of regular shares in which to invest. As a result, EPS is flat while the dollar amount of earnings is down 15% from its peak (falling from $1 trillion to $860 billion). This suggests the market is more expensive than it looks.

My conclusion is that the market’s modest new highs are probably justified, given the potential green shoots in earnings. But that doesn’t mean we’ll be back to 20% annual gains anytime soon—not unless or until we see sustainable earnings growth in both the level and rate of change, and hopefully a better quality of earnings to boot.

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1. Source: Bloomberg Finance L.P., as of July 22, 2016.
2. Source: FactSet Buyback Quarterly, as of June 23, 2016.
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