If you break the stock market down into its most basic elements only two things matter: earnings of companies and what investors are willing to pay for a dollar of earnings. This week, earnings season for the second quarter of 2018 was in full swing and investors are digesting the news. As of Thursday, roughly 43 percent of the S&P 500 companies have reported with year-over-year growth of 22 percent. Earnings growth has been robust this year due in part to the stimulus effect of corporate tax cuts which has had a material impact particularly on companies with a greater share of domestic earnings.
While it has been a good earnings season in aggregate it has not been without drama; shares of Facebook declined by nearly 19 percent on an earnings report that on the surface was a slight miss on revenues versus expectations for the quarter. What caused the sell-off was due to management comments that new privacy laws in Europe slowed advertising in the quarter and would continue to do so for the remainder of the year.
While the stock market is up over 6 percent this year, the market has become less expensive on a valuation basis. This is due to earnings growing faster than the stock market has appreciated. Put differently, what investors are willing to pay for a dollar of earnings has decreased.
This robust earnings growth gives us confidence in both the economy and in the continuation of the economic expansion. Additionally, there are indications companies are beginning to invest these earnings in capital expenditures as opposed to paying dividends or buying back stock. Investing in new property, manufacturing facilities and equipment increases worker productivity and has a multiplier effect in the economy, helping to extend the economic cycle.
Takeaways for the Week:
- The stock market has returned about 0.60 percent for the last week on good earnings and economic news
- Today the second quarter gross domestic product (GDP) was released. GDP, the value of all goods and services produced in the economy, increased at an annualized 4.1 percent rate - the most since 2014