When corporate profits are on the upswing, as they seem to be for the first time in more than a year, investors usually get excited. These are not usual times.
The reaction has been more "phew" than "hooray" for many fund managers this earnings reporting season, even with the Standard & Poor's 500 index on pace to report its first quarter of profit growth since the spring of 2015. The subdued reaction is the result of how expensive stocks have become. Earnings need to rise even faster than they are now to justify the market's lofty prices.
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The U.S. stock market "is certainly priced for perfection," says Maura Murphy, co-portfolio manager of the Loomis Sayles Multi-Asset Income fund. "If we don't see earnings pick up, that's a real risk because valuations are stretched."
Roughly half of the companies in the Standard & Poor's 500 index have already reported their results for the July-through-September quarter, and gains for banks and health care companies look to be offsetting continued drops for oil producers. Analysts expect to see earnings growth of 1.1 percent for the S&P 500 in the third quarter from a year earlier, according to FactSet. While that's certainly low, it's at least moving in the right direction.
Investors are banking on the gains getting even bigger. That's why investors continued to pay high prices for stocks over the last year, even as corporate profits dripped lower. Murphy says she expects growth to get back to the "high single-digit" percentage level that investors appear to be expecting, as interest rates remain low and the economy continues its modest pace forward.
Wall Street analysts are even more optimistic, and they are forecasting earnings growth of nearly 13 percent in 2017 for the S&P 500, according to FactSet. They foresee particularly big gains for energy companies on the assumption that the price of oil continues its recovery following its 70 percent plunge over 19 months from the summer of 2014 through early this year.
Others aren't so sure. Stephen Auth, chief investment officer for equities at Federated Investors, says he is feeling cautious about the market in the near term, even though he's optimistic about the long term, because growth in both corporate earnings and the economy has been sluggish.
He sees low interest rates hemming in profits for financial companies, and he doesn't see the price of oil making a big leap, a requirement for the energy sector to rebound. That's why he wouldn't be surprised to see the stock market stumble in the short term, before continuing to rise.
Strategists at Goldman Sachs recently ratcheted back their forecasts for S&P 500 earnings growth in 2016 and 2017. They expect the S&P 500 to end this year at 2,100, nearly 2 percent lower than Wednesday's closing level. The strategists are calling for the index to rise nearly 5 percent in 2017 to 2,200.
Fund managers want to see bigger earnings growth because stock prices have historically tracked corporate earnings trends. That's why the price-earnings ratio is a bedrock method used by many investors to measure whether a stock, or the market, is too expensive.
To see how pricey stocks have become, consider Exxon Mobil. Its share price earlier this month was 35 times larger than its earnings per share from the prior 12 months. That's much higher than its average price-earnings ratio of 12.8 over the last decade. The only way for Exxon Mobil's price-earnings ratio to get back to its historical average is either for its stock price to drop or for its earnings to get much bigger.
Exxon Mobil may be an extreme example because it's part of an energy sector that's struggling with the plummet in oil prices, but the overall S&P 500 is also trading at a significantly higher price-earnings ratio than its average over the last decade, 18 versus 14.8, according to FactSet.
"Most people that I talk to feel that valuations are stretched," Federated's Auth says.