Are Stock Market Levels Justified By Earnings Expectations?

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Includes: SPY, TLT
by: John M. Mason

Summary

Second quarter earnings projections are not expected to be that good and uncertainty hangs over corporate performance due to slow economic growth, slower inflation projections, and Brexit.

Bond prices and stock prices have moved in the same direction, an anomaly, the cause being the risk averse movement of funds into safe havens.

The performance in the stock market has come from dramatic increases in Utilities stocks and Telecommunications stocks, in companies that are financially strong and pay a higher yield than bonds.

The second quarter earnings reports are about to be announced.

What is to be expected?

"If expectations for the second quarter prove true, US companies will post their fifth straight year-over-year profit decline for the period-the worst stretch since the aftermath of the financial crisis," write Nicole Bullock and Adam Samson in the Financial Times.

"With the season set to get into full swing…analysts are forecasting a decline of 5.4 percent, according to FactSet."

With economic growth so dismal and with a recovery in inflation nowhere is sight, it is hard to see any improvement in corporate profits in the near future.

And, with the resolution of the British vote to leave the European Union up in the air, uncertainty is almost ubiquitous.

"Valuations may still be attractive, but what has deteriorated is the earnings picture," says Michael Arone, the chief investment strategist for State Street Global Advisors of Boston. "Until the UK begins renegotiations, nothing has actually changed….If we are still here this time next summer without clarity on the direction of Europe that will be a real problem."

The S&P 500 Stock Index closed at a new historical high on Monday, July 11, and is expected to go higher. The DJIA and the NASDAQ stock indexes are also flirting with new highs.

But, what is driving these new highs?

One factor seeming to play a huge part in these higher stock prices is the flow of funds occurring in the world, a flow that is connected with the movement of risk averse funds from world markets into "safe haven" countries like the United States.

A key toward the understanding of what is happening is that these funds have moved not only into stock prices but also into bond prices.

Usually, when risk averse flows of funds take place, the money flows into bonds, raising bond prices, but flows out of stocks, thereby, lowering stock prices.

In the current situation, these risk averse funds are flowing both into bonds and stocks, raising both bond prices and stock prices. How unusual….

In terms of the bond market, the yield on the ten-year US Treasury bond hit a historical low on Friday, July 8, of 1.361 percent. The day of the Brexit vote in the UK, this yield was 1.743 percent. So, bond prices have risen dramatically during this time period.

But, why are stock prices going up?

Well, the reason seems to be that investors would like a little more yield than is now being offered on bonds. Certain sectors of the stock market are providing this yield, with a degree of safety in this period of uncertainty.

Both year-over-year and year-to-date, the Utilities sector of the stock market and the Telecommunications sector of the stock market have been the number one and number two best performers. This information comes from the Market Laboratory on Stocks in the July 11 issue of Barron's.

The subsectors in each of these areas are made up primarily of strong, stable companies providing some kind of decent yield.

Year-over-year, the utilities sector is up by 22.58 percent and the telecommunications sector is up by 18.92 percent. Year-to-date, the utilities sector is up by 21.58 percent and the telecommunications sector is up by 20.79 percent.

The utilities sector and the telecommunications not only outperformed everyone else, they overwhelmingly outperformed everyone else.

Furthermore, most investors now believe that no central bank in the developed world, including the Federal Reserve System in the United States, will be raising interest rates this year and that these central banks, if anything, will continue to err on the side of monetary ease in order to support whatever economic growth might exist.

This central bank behavior, however, will not help the financial industry at all and this is shown up in the year-over-year and year-to-date performance of the financial sector of the stock market. Financials have been the worst performing sector this year according to Barron's and year-over-year it is the ninth worst performing sector with only the oil and gas sector doing worse.

The performance in the stock market appears to be connected with the performance of the bond market. Both performances seem to be a reaction to the flight of risk averse monies into safe havens.

But, can this continue is earnings are down in the second quarter for the fifth year in a row and if earnings are down 5.4 percent, year-over-year?

Is this any kind of scenario for continuing historic highs in the stock market indexes?

It is hard to justify record-setting stock prices based upon the uncertainty…and fear…of investors around the world. Yet, this seems to be the world that we are living in.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.