Earnings and Implications

US Q3 earnings season is coming to a close, with 482 of the S&P 500’s companies reporting as of Friday. And with 96.4% of companies reporting, the eighth straight quarter of overall earnings growth is all but assured, with profits logging a record high.

To date, S&P 500 companies have reported robust 17.8% year-over-year earnings growth. 70% exceeded analysts’ estimates, 10% met and 20% missed—both well above long-term averages.[i] What’s driving this growth? Companies remain lean—managing their cost structures and inventories effectively. But beyond that, revenue growth was broad as well—with sales rising 11%.

At a more granular level, growth occurred across all sectors—both in earnings and revenues. Energy was the overall leader, posting earnings growth of 59% and 26% revenue growth. Materials companies logged 32% and 15% earnings and revenue growth, respectively. Utilities were the weakest category—showing 1.8% earnings growth and a 2% revenue increase.

We’ve previously discussed a phenomenon we call valuation compression—an effect common during bull market corrections, wherein stock prices fall while revenues and profits rise. Thus, stocks get cheaper from both a dipping price numerator (P) and rising earnings (E, or S—sales) denominator—precisely what’s occurred in recent months, and particularly in Q3. Generally speaking, valuation compression would imply a disconnect between short-term price activity and the fundamentals underlying the business.

Some might argue Q3 earnings are inherently a thing of the past, so the “P” might better reflect the future economic conditions confronting US businesses. Possible, though focusing just on price action would provide an awful lot of false impressions about future business and economic conditions. Fortunately, data Friday provide some insight here, too.

October’s index of US Leading Economic Indicators (LEI) rose +0.9% m/m (+6.6% y/y)—sharply accelerating from September’s +0.1% m/m gain and beating analysts’ estimates of +0.6%. Of the ten components, only one posted a negative contribution—supplier deliveries’ minor -0.01% dip. Admittedly, there’s some wonkiness to the LEI’s components (for one, a minor component is stock prices, subject to inherent short-term volatility). But the broader point remains—the LEI isn’t indicating economic weakness ahead, which would seemingly imply near-future US economic conditions aren’t a headwind to corporate business results, they’re a tailwind.

To be sure, there are other factors to consider. For example, US companies do derive much of their sales abroad. But for all the talk of dire conditions and meager economic growth in Europe (and there are problems, to be sure), excluding the UK, they’re 24% of the world economy. (Not to mention, conditions aren’t uniform country-to-country in Europe.) The remaining 76% of the world is growing quicker—like the US and Emerging Markets in total.

Some analysts are lowering their expectations for Q4 corporate results, with many pointing to eurozone weakness. But analysts have done the exact same thing, quarter after quarter, throughout 2011 (and 2010 before it)—citing reasons from Japan’s earthquake to Europe. So take these dampened expectations with a grain of salt.

Ultimately, there’s little reason current global and US macroeconomic conditions pose a sufficiently negative headwind to truly reverse the private sector’s growth. Could that change? Sure, but it’d likely take a sizable, negative shock—not the continued drip of widely watched and expected eurozone news. So it seems to us the valuation compression we’ve seen recently is mostly the result of two factors: Dour, correctionary sentiment disconnected from fundamentals’ reality, and rising profits and sales that aren’t. Maybe earnings growth slows ahead—wouldn’t be very surprising after two torrid years. But at the same time, we fully expect you’ve not seen the last earnings season in this cycle to show growth.