Is the market headed for a drop?

Advisors and analysts are busy watching the Federal Reserve’s every word on future interest rates. But they should be keeping an eye on corporate earnings as well, argued Charles Schwab (SCHW) Chief Global Investment Strategist Jeff Kleintop.

“The gap between estimates for the year ahead and actual earnings is now the widest since 2009,” Kleintop warned in a report on Monday.

But unlike 2009, today’s earnings slump is not being accompanied by a global recession, which would be followed by a sharp rebound in the economy and earnings, he pointed out.

“For the past six months, global stocks have been supported by an improving earnings outlook, but with expectations stretched, stocks are vulnerable to a pullback if actual earnings fail to deliver on the promise of better growth,” the strategist explained.

For 18 months, many analysts trimmed earnings estimates for global companies by a total of 14%, he said, but then they spent the past six months raising them. “Are they now expecting too much?” Kleintop asked, noting that while earnings estimates are rising, actual earnings are falling.

There were good reasons in ‘09 for optimism driving a wide gap between actual earnings for the prior year and earnings estimates for the coming year, and earnings doubled over the next two years thanks to a rebound in the global economy, Klentop said.

In 2010 and 2011, global GDP growth ticked up 5.4% and 4.2%, respectively (a similar chain of events took place in 2002, according to Kleintop).

Future Faultlines

Can a similarly powerful rebound in earnings be expected today?

“We doubt it,” the Schwab strategist said. He pointed out the slump in earnings in recent years did not go hand in hand with a global recession, which would have seen a sharp rebound of global growth of 5% and then a corresponding jump in earnings.

“Instead, economists expect more of the same sluggish growth in 2017,” he said, noting that the IMF sees global GDP accelerating to 3.4% in 2017 from 3.1% in 2016, and many analysts believe even these estimates to be too rosy),

“While that doesn’t rule out a modest turnaround in earnings, it does make the consensus forecast for more than 20% earnings growth over the next year at risk of being overly optimistic,” Kleintop stated. 

Stocks have been rising since February, he noted, thanks in part to the improving earnings outlook. “However, the recent slowing pace of the gains along with the wide gap between estimates and actual earnings suggests an increasing need for actual earnings to start to improve and validate analysts’ optimism,” the Schwab analyst cautioned.

He added it is critical for advisors and investors to pay attention to the gap since the earnings outlook “is arguably the most important driver of the stock market.”

The strategist warned, “The potential for the return of volatility is a reminder that rebalancing back to your strategic asset allocation targets may be a smart idea.”