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Can Earnings Season Help Stocks Avoid an Overdue Correction?

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Stock investors have reason to worry about a correction beyond the fact that the post-election rally has stalled and this bull market is an unusually long one. Now in its ninth year, this bull market has lasted longer than all but one since World War II. A correction is overdue, and the possible catalysts for one were discussed in a recent CFRA webcast, “Sell in May, or Will EPS Growth Save the Day?”

Stocks Are Expensive

The S&P 500 is trading at about 24 times trailing 12-month GAAP earnings, which is a 17% premium to the median P/E since 1988 and 42% premium since 1958, according to Sam Stovall, chief investment strategist for equity research at CFRA. The trailing P/E for operating earnings is 20 times, a 14% premium to the median since 1988.

(Related: The Bull Market Is 8 Years Old. What’s Next?)

Even Federal Reserve policymakers are concerned about the stock market’s valuation. Minutes their last FOMC meeting noted that “some participants viewed equity prices as quite high relative to standard valuation measures.”

‘Tis Almost the Season for Disappointment

The 100-day grace period for the new U.S. president, during which stocks rallied to record highs in early March, concludes at the end of April, just before the “sell in May and go away” market adage could become relevant.

(Related: 3 Ways to Tell if the Bull Still Has Room to Run)

Since World War II, the S&P 500 has gained an average 1.6% from May through October, compared to 6.7% from November through April, said Stovall, noting that the pattern applies also to small-cap U.S. stocks as well as emerging market indexes.

“Because we’re looking at an old market …  [and] at relatively expensive market, one mentally has to be prepared for the possibility” of slipping into a “challenging period,” said Stovall. “Stocks to appear vulnerable.” 

What Happens in First Year of First-Term Republican Presidents

The May through October season can be particularly challenging during the first year of a first-term Republican president.

Since World War II, the S&P 500 has fallen 80% of the time during those months in the first year of a first-term Republican president, and the decline has averaged 4%, according to Stovall. (For a first-term Democrat during that season the S&P 500 has risen 83% of the time, posting an average 5.7% gain.)

These trends reverse during the November – April period. For a Republican first-term president stocks have risen 80% of the time, with an average 0.7% gain. For a Democratic first-term president the stock market has fallen 70% of the time, posting an average 3.3% loss but during the first year of a first-term Republican president, it has risen 80% of the time, with an average gain of 0.7%.

(Related: Trump’s Policies: Market Impact vs. Economic Impact)

The reality of the current political environment in the U.S. and abroad is having an impact on the stock market, wrote Stovall in his Wednesday market note.

“Uncertainty over the U.S. debt ceiling and the possible shutdown of the U.S. government, heightened geopolitical tensions, the March miss in non-farm payrolls, a less-than-encouraging rise in core CPI, a sub-1.5% projected gain in Q1 GDP, and the lessening of optimism that a Trump tax-reform bill will pass before Congress’ August recess” are all accumulating in an “an ever-rising wall of worry” for investors, according to Stovall.

Can Earnings Save the Day?

Despite the recent retreat from a March 1 peak, the S&P 500 could rise as high as 2,500 – it closed Wednesday at 2,338 – if earnings rise 20%, said Stovall, adding that the likelihood of that happening rises if the marginal corporate tax rate drops to between 20% and 25% from 35% to 39% currently.

(Related: Market’s Moves Not All About Trump: Sonders)

Every 1% decline in the corporate tax rate could raise earnings by an equal amount, assuming the inflation rate holds steady, according to Stovall. But if corporate tax reform dies or the tax cut is smaller than 10 percentage points and the sequestration mindset of Congress continues – which would require that any increase then 2,500 will be hard to achieve, said Stovall. “We’re already overvalued.”

In an even more recent analysis, Stovall noted that early misses in first-quarter earnings “have cast a pall over the early stage of the Q1 EPS reporting period” even though year-over-year earnings expectations have risen to 10.1% for the S&P 500 from a recent 9.7% estimate.

According to Lindsay Bell, CFRA investment strategist, who also participated in the webcast, earnings forecasts have been declining since the beginning of the year, as they usually do, but not because of disappointment that President Trump’s economic and regulatory promises have not been realized.

“Trump’s promises and their potential benefits are not priced into earnings forecasts, only in stock prices,” said Bell. “It will be interesting to listen to what corporate management has to say about their outlooks [during this current earnings season] for the remainder of the year. That could be foretelling.”

She said stocks are now trading at a forward 12-month P/E of 18.2 times, which is expensive and at a premium but below the premium during the tech bubble and something that she think the market can live with. Earnings expectations are highest for energy, followed by tech, then financials, said Bell.

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