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The Stock Market Rally Is a Big Fat Lie

Last Updated September 23, 2020 1:12 PM
Sam Bourgi
Last Updated September 23, 2020 1:12 PM
  • S&P 500 Index shatters new record high on Monday.
  • Equity markets are rallying despite a three-quarter decline in corporate earnings – the longest stretch since 2015-16.
  • U.S. firms are getting better at playing the expectations game.

The Wall Street expectations game has created an artificially low hurdle for companies to clear every earnings quarter. Case in point: Corporate America is back in a technical earnings recession, yet stocks are pushing record highs again.

Another Disappointing Earnings Quarter for Wall Street

U.S. stocks raced toward record highs on Monday after a pair of earnings reports  from Walgreens Boots Alliance (NYSE:WBA) and AT&T (NYSE:T) came in better than expected.

Earnings-inspired gains have been going on for a couple of weeks now, with investors rallying behind positive headlines from big banks and technology juggernauts. The problem with this picture is that corporate earnings have been poor when compared to last year.

By Friday’s close, 40% of the companies in the S&P 500 reported third-quarter results. Their blended earnings decline  for the quarter is 3.7%. according to FactSet. In other words, earnings are down nearly 4% compared with a year ago. If the trend continues (and it looks like it will), Q3 2019 would mark the third consecutive quarter of year-over-year profit declines – the longest stretch in three-and-a-half years.

S&P 500 corporate earnings
Energy and technology sectors are the biggest contributors to negative earnings growth for companies with more global exposure. | Chart: FactSet

Despite the downtrend, FactSet says 80% of companies to have reported so far have exceeded Wall Street’s profit expectations. Nearly two-thirds (64%) have produced stronger than expected revenues. Perhaps investors haven’t clued in to the artificially low hurdle the Wall Street expectations game has created. As FactSet data clearly show, generating earnings that are ‘higher than expected’ doesn’t take very much.

Companies are Getting Better at Playing the Game

As MarketWatch reported all the way back in 2016 during the last earnings recession, companies have “become more skilled” at playing the expectations game  over the years. And that’s a tall order, too, since it requires suppressing guidance for several quarters (perhaps even years).

As Mark Hulbert reported at the time,

“Beating expectations has now become expected…”

Several companies have already laid the groundwork for another ‘better than expected’ quarter to end the year. Already, 26 S&P 500 components have set the bar low with respect to Q4, issuing negative earnings guidance compared with only 12 that have released positive outlooks (and the positives are probably understated, too).

Macro Risks Weigh on Earnings

Corporations are trying to manage expectations at a delicate time for the global economy. A synchronized slowdown in global growth, U.S.-China trade uncertainty and the impact of a stronger dollar are all being felt on companies with exposure to international markets.

As CCN.com reported earlier this month, Corporate America is more likely to complain about foreign exchange rates than they are about the trade war. Recession fears and an apparent liquidity shortage in global banks catapulted the dollar to two-year highs in September. The dollar has since retraced much of that rally, but it should maintain support as quantitative easing and Brexit undermine other currencies.

As the Federal Reserve’s latest actions show, the dollar isn’t immune from the vicious cycle of money printing, but the U.S. economy is still in better shape than many of its advanced industrialized peers overseas. At least, that’s what GDP numbers show.