Stocks Defy Margins, Earnings

It’s been a busy week so let’s jump right in. We’ll begin today with a brief look at where markets stand, get caught up to speed on the earnings front, and then examine recent trends in the latest economic data.

A one-year chart of the S&P 500 is posted below, and as you can see, the index is holding steady above its September high. I still find this V-shaped rally to be remarkable considering it has come entirely as a result of multiple expansion and in the face of declining/decelerating earnings.

S&P 500

Other major averages remain bullish, but aren’t showing as much outright strength as the large-cap index. Below we can see that both the Industrials and Transports, while in uptrends, have not surpassed their respective 2018 highs.

Dow Jones Industrials and Transports

The Nasdaq is the other average that has joined the S&P in breaking out to new highs (top panel below), but a big decline in Google shares today on the back of weak earnings is pulling the index back toward that key level.

Small caps, represented by the Russell 2000 and pictured in the lower panel below, also remain a ways off their 2018 highs.

Nasdaq and Russell 2000

As for market breadth, both the NYSE Advance-Decline line, as well as the common-stock only version of the same measure, are hitting new highs. This suggests that participation remains strong.

In terms of sector relative strength, right now it’s the cyclical sectors leading the way higher (technology, consumer discretionary and communication services), while defensive sectors (consumer staples, health care and utilities) take up the rear. Altogether, price action remains bullish with few notable pockets of weakness.

Moving on to earnings, approximately half of the S&P 500 has now reported. With 77% of companies beating their EPS estimates, blended earnings growth for the 1st quarter currently sits at -2.3% (FactSet). This stands in contrast to blended revenue growth of 5.1%.

The fact that revenues are growing while earnings are shrinking points to declining net profit margins, and that is indeed what we’re seeing. In the chart below we can see that the net profit margin for the 1st quarter is on track to hit 10.9%, the lowest level in four quarters.

S&P 500 Net Profit Margins

There are a number of possible reasons for this, but they generally boil down to higher costs in the form of labor and materials. We know that labor costs have been rising as a result of the strong labor market, and that is evidenced in the chart below.

The employment cost index measures how much companies, governments and nonprofits pay employees in the form of wages and benefits. As you can see, the cost to employers has been accelerating since 2015.

Employment Cost Index

The most recent data, released today, showed a small decline in annual employment cost growth, but considering how strong the labor market is, I think this will continue to be a headwind for margins.

Material costs have also been rising steadily and that has added to the decline in profit margins. Both of these factors have been heavily sited by companies on their earnings calls.

One of the dynamics I find particularly interesting is that the consensus currently calls for an earnings recession here in the U.S. (back-to-back quarters of declining year-over-year earnings), yet the market, at least as measured by the S&P 500, is notching new highs.

Expected Earnings Per Share Growth Rates by Geography

The last time we had an earnings recession here in the States was back in 2015 – 2016, and in case you don’t remember, the market didn’t care for it. Rather than hitting new highs, the S&P was extremely volatile and experienced some sharp drawdowns.

What’s more, as the chart from LPL Research below shows, generally speaking the market reacts poorly to these types of environments. According to LPL, there have been 12 earnings recessions since 1954. While three of them were not accompanied by economic recessions, they were all accompanied by declining stock prices.

Earnings Recessions

This suggests to me one of two things. Either the investor community believes that the consensus for earnings is too low, and we won’t have an earnings recession (this is plausible, considering that actual earnings consistently come in better than expected by about 4-5 percentage points – see last week’s commentary for more on this), or investors are being complacent. If it’s the latter, I would imagine we’ll see prices move sideways or lower over the coming weeks and months.

As I try and reconcile the weak earnings outlook with current price action, the one thing that stands out is the positive revenue growth. Analysts aren’t expecting revenue growth to decline on a year-over-year basis at all this year, so perhaps bullish investors are basing their outlook on the hope that top line growth will continue.

Now let’s quickly get caught up on the latest round of economic data.

On Friday we got the initial reading on first quarter GDP, and it came in much stronger than expected at 3.2%. This marks an acceleration from the 4th quarter.

Real GDP

While this is a good sign, our enthusiasm should be tempered by a couple of facts. First, a strong inventory buildup contributed about 70 basis points (0.7%) to the growth figure. This extra inventory will likely act as a drag on growth in coming quarters as it’s worked off.

In addition, the growth in inventories is hard to account for in the sense that both production and imports fell during the quarter. This left some economists scratching their heads as to where the extra inventory came from, and gave them an uneasy feeling that perhaps part of the strong GDP report had to do with seasonality.

Some of you will recall that first quarter GDP has had a habit of always coming in weak, likely due to errors in how seasonality factors are applied. It’s possible that changes in the seasonality methodology are partly responsible for the strong gain. At any rate, we’ll get more clues as the data is finalized and revised.

A few other key economic data points were also released over the last week. Durable goods orders posted a strong increase in March (2.7%), but as you can see below, growth on year-over-year basis continues to moderate.

Durable Goods Orders

Personal Income rose 0.1% for March, and continues to expand at a roughly 4% nominal rate.

Personal Income

That has supported consumer spending, shown below, which is also continues to rise steadily. This suggests that the consumer remains fine, which of course is very important considering consumer spending accounts for two thirds of the economy.

Consumer Spending

We also received updates on the Fed’s preferred inflation measure – the PCE – which had been delayed due to the government shutdown. Headline inflation is currently up 1.5% year-over-year, while core inflation (excluding food and energy) is up 1.6%.

Personal Consumption Expenditures

Both of these figures are well below the Fed’s 2% target, and that suggests the Fed will continue to remain on hold for some time. We also continue to hear Fed officials discuss the possible adoption of a new inflation targeting framework, which itself has dovish implications. In short, the Fed most likely won’t be raising rates for a long time.

Finally, the last topic I want to briefly touch on is housing. The latest Case-Shiller home price data was released today and showed that nationwide, homes have appreciated 3.2% over the past year. This is the slowest rate of growth since September 2012.

Case-Shiller 20-City Composite Home Price Index

If you’re interested in seeing how home prices have been faring in your closest metropolitan area, the individual 20-city data is displayed below.

Case-Shiller Home Price by Metropolitan Area

Rising home prices have been a steady tailwind during most of this economic expansion. While that tailwind hasn’t gone away completely, it is starting to slow.

The good news is that with the recent and sustained drop in the 10-year Treasury yield, mortgage rates have been falling and that has led to a resurgence in demand. The National Association of Realtor’s index of pending home sales rose 3.8% in March, a sign that buyers are again stepping back into the market.

If inflation continues to remain suppressed (which keeps long-term interest rates down) and the labor market stays firm, housing should hold up just fine.

Wrapping things up, all the data that we’ve looked at today paints a picture of a slow but steadily growing economy. It would seem that near-term recession risks remain low, as the primary drivers of U.S. economic growth (consumers and businesses) remain healthy.

That said, the stock market has risen dramatically over the last four months and now trades at a historical premium. Considering the lackluster outlook for profit and revenue growth, it wouldn’t surprise me to see prices move sideways to lower in the near-term.

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