The year 2017 was, of course, extremely positive for U.S. stocks, with every major stock market index trending higher by double-digit percentages. In addition to the general stock indexes trending higher, many widely held U.S. stocks had a strong year as well.
Coming into 2018, as an investor, I felt I was entering a wait-and-see mode. After 14 months of robust market performance following the November 2016 Presidential election, I needed to see the performance of the stock market validated by some substantially improving fundamentals.
After all, I felt like I had a good understanding of the initial charge to the rally. I had observed the federal regulatory culture had become very burdensome during the Obama administration, and just the idea this trend could be realigned was enough spark to start a rally.
After this initial trigger, the promise of an improved tax environment was the near perfect tailwind to keep the rally going. By the beginning of 2018, however, the stock market seemed to have gotten a little ahead of itself.
Known to be prone to excesses on both sides of the spectrum, stocks in general looked a little expensive by historical standards, and with the Federal Reserve clearly forecasting its intent to raise interest rates through 2018, I wasn’t surprised at all to see the rally pause during the first quarter of 2018. I felt if stocks were going to continue to move higher, the market was going to need a new spark to reignite enthusiasm among investors.
I remember having a conversation with a client who I’ve felt was a good investor. He said, "We got the tax cut, corporate profits are good, but now stocks are expensive. How are we going to go higher from here?"
My answer was, “Earnings will have to surprise to the upside, making stocks less expensive. Otherwise it’ll be tough.”
Enter the first quarter 2018 earnings season. According to stock and market research firm FactSet, as of May 4, 81 percent of U.S. companies have reported their first quarter profits, and of those 81 percent, 78 percent reported profits which exceeded their original profit estimates.
In addition, and perhaps more importantly, 77 percent also reported higher than expected sales numbers. If this trend continues through the remainder of the current earnings season, it will be the strongest earnings season for positive earnings surprises since 2003.
Also according to FactSet data, this exceptional performance in corporate profits has readjusted the forward looking price to earnings (P/E) ratio of the benchmark S&P 500 (remember it is impossible to invest in an index) to 16, which is now below the median P/E ratio in the index of 17.7 dating back to 1971.
So in simple terms, with higher corporate profits, stocks have become less expensive from a historical perspective.
Does this mean I think it's all “up, up, up” from here on out? Definitely not, but in order for the U.S. stock market to break out of its current volatile but range-bound behavior cycle, in my opinion a widely based positive earnings season was a necessary prerequisite.
We still have some instability and uncertainty with interest rates, and the geo-political environment is as precarious as I can remember, but ultimately corporate profits drive stock prices. And at least on this level, it looks like we have a green light to go higher.