Closing the Gap

Peter 2017-04.jpg

trade tensions between China and the U.S., an overly-aggressive Federal Reserve, and viewed earnings expectations as too high. Just one month later, investors are sanguine on U.S.-China trade discussion, the Fed has turned more dovish, and corporate earnings releases are being rewarded.

Over the long-term, stock prices follow earnings, but investor psychology can drive periodic dislocation between the two, an event which is shown in the chart below. Stock prices have been driven by rising corporate earnings until late last year, when the fears discussed earlier caused a large divergence between the two.

Source: FactSet

Source: FactSet

For the first month in 2019, the substantial rally in the markets has not been driven by rising corporate earnings. Instead, stock prices have climbed simply by a re-convergence to the levels suggested by earnings.

When investor sentiment is poor (e.g., blue line below the green line) the threshold for positive surprises is much lower than for periods when sentiment is strong. In the past few weeks, this phenomenon is embodied by stock price reactions to corporate fourth quarter earnings releases. For the last couple of years, there was a negative skew to corporate earnings. In other words, companies that had poor results were penalized by a larger magnitude than the reward for companies with strong results. As shown in the chart below, the opposite is occurring.

Source: Credit Suisse

Source: Credit Suisse

Companies that report stronger than expected revenues and earnings have risen by 4.4 percent on average whereas companies that have missed revenues and earnings have declined by just 1.9 percent. Now that stocks have rallied 15 percent from their Christmas Eve lows, we expect the threshold for positive surprises to begin rising once again. Now that stock prices have converged with earnings (first chart) it will have to be rising profits, not mean reversion, that drive stocks higher from here.

Week in Review and Our Takeaways:

  • Stocks returned 8 percent in January, the best start in 30 years

  • The U.S. government shutdown had a limited impact on hiring decisions as the U.S. economy added 300,000 jobs in January

  • Further gains in markets will be driven by rising corporate profits