Intuitively, when a company beats earnings expectations, the share price should go up. Under performing expectations should see prices go down. And meeting expectations should keep prices relatively unchanged. The price action as a result of Q1 2018 earnings has been anything but intuitive, and is beginning to expose the cracks in the U.S. equity market.
From tax reform to higher GDP growth expectations, investors will try to figure out what is “priced in” to the market and what is not. The problem about determining what is and isn’t priced in is that it is extremely difficult to prove it one way or another. One of the few times during the year when we get to directly see how the market reacts to specific news events is during the four quarterly reporting seasons. What we have been seeing in the the most recent quarterly earnings reports has been unusual and demonstrates the extent to which the U.S. market has priced in the goldilocks, or ideal, scenario.
The chart below shows the earnings estimates for companies within the S&P 500 alongside the actual performance of the index.
Via Blackrock Investment Institute
As you can see, while earnings estimates have been continually growing, the returns on the S&P 500 have been declining. The extraordinarily high earnings expectations have outpaced the actual earnings growth and as a result the S&P 500 has responded in a mixed manner. Across numerous companies, earnings beats and meets have been met with lackluster and even negative responses in price.
So what does this all mean? When expectations are so high that meeting them isn’t enough, it may be time to look elsewhere for equity risk exposure. Value can certainly be found within single companies in the U.S. market, although it is becoming harder and harder to find. For more broad equity market exposure, relative value is more likely to be found in developed international and emerging market stocks. To learn more about how we at Twelve Points allocate, read our article Why Non-U.S. Equities Should Be A Core Part of Your Portfolio.
