High Hopes and Low Expectations

by Ralph Cole, CFA Executive Vice President of Research

Someone once told me that the secret to a happy life is low expectations. While a melancholy motto, it aptly captures the mood of the current earnings season. The S&P 500 has rallied from the depths of January, and is now positive for the year - this despite earnings estimates dropping rather precipitously since the start of 2016. With a weak dollar and higher oil prices, we believe that earnings estimates for the full year are now too low.

So far this quarter, 134 of the 500 companies in the S&P 500 reported earnings. Of those, 77 percent have reported positive earnings surprises. Earnings have been strong in consumer discretionary, financials (mainly banks) and the industrial sectors. We believe the industrial and bank sectors are especially important, because they are large and have been laggards year-to-date. Improved bank earnings are reflecting a strong consumer and robust credit quality while industrial companies are starting to benefit from a weaker dollar and some improvement in the global economy.

Higher and Higher?

Since bottoming on February 11, both interest rates and oil prices have been steadily climbing. West Texas crude prices bottomed at $26.19 a barrel, while the U.S. 10-year Treasury was yielding just 1.66 percent. Both are considerably higher today with oil trading at almost $44 dollars a barrel, and the U.S. 10-year at 1.88 percent. We think both of these trends have positive implications for the economy and the market.

Higher yields relieve some of the net interest margin (NIM) pressure that lenders have been experiencing with lower rates over the past several years. The other insight we infer from higher rates is higher expectations for inflation. While fears of deflation have haunted central banks around the world, the Federal Reserve is currently breathing a small sigh of relief.

Higher inflation expectations are a direct reflection of higher oil prices. Not only do higher oil prices reflect a drop in U.S. oil production, but we believe higher oil prices also reflect an improving global economy. Ultimately, the key to higher oil prices and stock prices this year is faster growth in the global economy.

Our Takeaways for the Week:

  • Stock prices tend to do better in earnings seasons when expectations are low
  • An improving global economy has put a bid into interest rates and oil