Is earnings growth as good as it will get?
Here’s the challenge when something’s as good as it gets: What comes next?
Companies across industries are in the midst of reporting another quarter of gargantuan profit growth, driven by lower tax bills and a growing economy. Amazon said its net income surged more than tenfold during the summer from a year earlier, for example.
Yet stock prices are not getting the boost that they usually do when companies report better-than-expected earnings. On the flip side, investors have punished stocks much more severely when companies have fallen short of profit expectations.
Altogether the S&P 500 is still down about 4 percent since the start of October. That’s despite the index being on track to deliver roughly 25 percent growth in earnings per share for the third straight quarter. More than four-fifths of companies in the index have reported results.
The reaction can be tied to the gnawing concern among investors that this may be the peak for corporate profit growth. Analysts say growth may slow to a roughly 15 percent rate in the last three months of the year.
In conference calls with analysts following their earnings reports, CEOs have been citing several challenges, including rising expenses, President Donald Trump’s tariffs, and slowing economic growth in countries around the world.
When Amazon reported its results in October, it gave a forecast for revenue this quarter that fell short of analysts’ expectations. Part of that was due to the expected effect of a strengthening U.S. dollar, which can dilute the value of sales made abroad.
The weaker-than-expected revenue forecast helped sink Amazon’s stock by 7.8 percent the day after its profit report, even though its net income far exceeded analysts’ expectations.
Next year, profit growth is likely to fall off even more sharply for Corporate America because companies will no longer be getting the big boost provided by a sharp drop in their income-tax rates. That is, unless Washington approves yet another tax cut, which is unlikely now that Democrats have gained control of the House of Representatives.
Earnings growth may run at about 9 percent next year for S&P 500 companies. That would be a good showing during normal times, particularly about a decade into an economic expansion, but it would also be less than half this year’s rate.
Are stocks overpriced?
The growth expectations are key because stock prices tend to track corporate profits over the long term. When profits are surging, it gives investors more reason to pay high prices for stocks. The S&P 500 index set a record on Sept. 20.
Most professional investors say stocks look either fairly valued or still a bit expensive relative to how much profit they produce. The S&P 500 is trading at 16.1 times its expected earnings per share over the next 12 months, for example. That’s a more expensive price-to-earnings ratio than its average of 14.7 over the last 15 years.
For stocks to look more attractive, either prices need to drop or earnings need to rise more. That’s why investors are putting so much emphasis on what comes next.