Fitting the Earnings Shoe

The first quarter started with a bang but ended with a thud.  The US stock market was basically flat and the bond market was modestly up.  The widespread global recession rhetoric seems to be quieting. This is particularly true in the US where we have been pointing out economic conditions are not as bad as they seem.

But for the markets, the next scare is always on the horizon, and right now that looks to be declining corporate earnings.  The corporate profits chart below (courtesy of the Federal Reserve Bank of St Louis) shows why some may think earnings are the next shoe to drop.



Yet again, things may not be as bad as they seem.  The recent decline is mostly attributable to the capitulation of the energy sector.  In fact, according to Thomson Reuters, earnings have actually been increasing when energy is excluded.

Does this mean there is absolutely nothing to worry about?  Of course not.  The fact is both corporate earnings and margins are above average, and will likely mean-revert over time.  However, just as the US economy was unlikely heading into some global death spiral in January, corporate earnings are also unlikely to be doing so now.

If anything, the earnings bar has actually been lowered for an upside surprise in 2016. Oil prices are up 50% from their lows — welcome news for the energy sector. If the energy sector simply loses less moving forward, that already improves earnings.  And an outright recovery in energy earnings means a big boost.

The bottom line is the recent earnings decline isn’t due to widespread weakening demand.  Being very much an energy-focused situation, we may actually see an improvement in earnings before a period of prolonged deterioration.  This combined with our muddling-along economic outlook points to an unlikely broad and deep market decline near-term.

Victor K. Lai, CFA

This blog is for informational purposes only. Nothing on this blog represents advice. Investing is inherently risky and involves the potential for loss.