The bottom line is once again, strong earnings. We know earnings drive long term stock gains, and fortunately that’s what we’ve been seeing.
Earnings that are driving long-term stock gains and the second-quarter earnings season are wrapping up a very impressive quarter. Earnings for all of 2018 could now be close to 20% and up another 10% next year. Of course, tax reform has helped fuel some of the gains, but improving confidence and a strengthening economy contributed as well. Although trade worries have dominated the media, it was very encouraging to see earnings estimates for the next four quarters increase, suggesting the trade worries haven’t affected corporate America yet.
Also discussed was the first S&P 500 record high since late January of this year and why that could have bulls smiling, and how the US dollar affects global earnings.
The Fed was also in the news last week, as Federal Reserve Chairman Jerome Powell spoke at the Jackson Hole Symposium. The speech was viewed as being slightly dovish, but we were encouraged by Powell’s comments, which expressed his commitment to flexibility. His overall approach is cautious and measured, which we believe greatly reduces the Fed’s chances of a policy mistake.
S&P 500 earnings continue to be very strong, with potentially 20% earnings growth coming in 2018 and another 10% in 2019. Earnings drive long-term stock gains and this should be a positive for the overall bull market.
After Fed Chair Jerome Powell’s speech at the Economic Policy Symposium in Jackson Hole, WY last week the futures market is pricing in a near certainty of a rate hike at the Fed’s next meeting in September.
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Ryan Detrick: Bottom line is once again strong earnings. We know earnings drive long-term stock gains and fortunately that's what we've been seeing. On the first quarter, we saw a 26% year over year earnings growth. The second quarter is looking like we're going to hit right about 25% year over year. We can get into peak earnings and what does that mean. The bottom line, a 25% year over year earnings growth really strong.
John Lynch: Welcome to LPL Financial's Market Signals Podcast. I'm John Lynch, chief investment strategist at LPL Research. Today I'm here with Ryan Detrick, senior market strategist at LPL. Good morning, Ryan.
Ryan Detrick: Good morning, John. Welcome to be back and looking forward to a fun day.
John Lynch: Yeah, I'm excited. We've got a lot more to discuss this week as we've done in past weeks. I guess first and foremost we want to cover earnings. We'll want to discuss the Federal Reserve and monetary policy impacts. We'd certainly like to talk about the market having hit new highs most recently on many of the major indices, three of the past top four indices. I'm sure we have some currency impacts to discuss as well. Why don't we start off with earnings? We've seen some really good numbers. Ryan, would you like to talk about the second quarter?
Ryan Detrick: Yeah, John. I will. That's right. Earning season is wrapping up. I believe there's about 15 companies left to report. The bottom line is once again strong earnings. We know earnings drive long-term stock gains and fortunately that's what we've been seeing. On the first quarter, we saw a 26% year over year earnings growth. The second quarter is looking like we're going to hit right about 25% year over year. We can get into peak earnings and what does that mean. The bottom line, a 25% year over year earnings growth really strong. The other thing, you know, you can argue maybe. I don't want to get too out there, but you can say maybe there's financial engineering.
Maybe you can kind of fudge earnings a little bit, but revenue, John, was up still 10%. Like 9.9%. It's tough to fudge that one. Really strong earnings. Economy looks good and revenue also really up strongly.
John Lynch: Yeah. I think that's an important point to make because a lot of investors are seeing coverage that is suggesting it's all due to tax cuts. If you look at earnings before interests and taxes or EBITDA, taken depreciation, amortization as well, we're still seeing very good numbers. I think that's important for investors to keep in mind. As you mentioned, very strong sales growth. Margins are very important as well. You see some of the weakness in the commodity space, which kind of disappoints many of us if you look at copper for example as a forward looking indicator.
Nonetheless, if you factor in the weaker commodity situation as well as the absence of threatening wage growth, those are the primary cause of doing business for you as a business. I think that also bodes well for continued profit growth.
Ryan Detrick: That's right. You mentioned something important I want to focus on. We know tax reform's a big reason why earnings have been strong. Even if you take out the benefits of tax reform, we're still looking at 18 to 19% earnings growth in the second quarter. This isn't just all because of tax reform. Sure, that helps. We get it, but there's definitely some other factors or strength underlying in the economy there. One other thing, there's 11 sectors, the S&P 500. All 11 are looking at positive earnings growth this second quarter. We talk about market breadth so to speak. Well, there's market breadth when it comes to earnings as various sectors have been doing well.
Once again who really led? Technology. I mean the biggest group, probably the most influential in the S&P 500. Technology had a really strong earning season yet again.
John Lynch: Absolutely. When we wrote our 2018 market outlook, we called it return of the business cycle. Not to suggest that it was the early innings of the cycle as you know, but more to suggest that we returned to the normal drivers of the business cycle when you think about whether it be fiscal policy, transitioning from monetary leadership with the Fed just cutting rates for example, tax cuts, reduced regulatory burdens, increased governing spending. When you look at, to your point, about the broader market, it's not just FANGs.
We're looking at all 11 sectors contributing from a profit standpoint, but also keep in mind that those beneficiaries, whether it be financials, industrials, energy, technology, small caps, you're seeing leadership from all those areas particularly given the industries within those segments if you will of the market that are benefiting from the regulatory environment, the fiscal environment, as well as the government spending environment.
Ryan Detrick: That's right, John. Maybe I'll wrap it up like this. This is going to be the 37th quarter in a row now that the actual earnings came in better than the estimates. It's pretty amazing when you think about it. That's a long time. At the same time, we've gone awhile so far during this podcast. I haven't mentioned trade wars yet. I think we did good by ignoring them so far, but the bottom line though, John, if you look at what companies are saying going out four quarters actually increased this recent earning seasons. That's rare. Usually it goes down 2 to 3%.
Trade wars are there, but really Corporate American didn't seem too concerned this earning season with trade wars. What do you think about that?
John Lynch: Absolutely. The trade war certainly I think many investors are viewing it more as a negotiating tactic if you will, but nonetheless, we have to be mindful of the fact what that could do for sentiment, what that could do for capex plans. Maybe some businesses are holding back. We're seeing some of that. We'll get into the Fed in a minute because that's some of the concern of Fed officials, but you mentioned something about peak earnings and I think it's terribly important to get this point across to investors. If we go to 24% in the first quarter, 25% in the second quarter, there's a lot of concern as to whether or not we're actually peaking in earnings.
It's terribly important for investors to recognize that a peak in the rate of growth in earnings on a year over year basis is not a peak in profitability. We're still looking at up to 10% profit growth next year. Yes, it's down from 25% on a year over year basis. However, 10% is still a good number. It's still a premium to historical averages. As you know, Ryan, when we wrote our midyear outlook, the plot thickens for 2018.
Our research team highlighted that over the past 10 cycles, you could have a peak in year over year percentage growth in profitability, yet historically over 10 cycles we found that it took almost four years for the economy to slip into recession after that peak in profitability. Perhaps most important is the market reaction during that four period where it's certainly not a straight line. Market cumulatively had gained north of 50%.
Ryan Detrick: That's right. You know, a lot of positives there when you look about earnings. Let's change gears for a second, John. Clearly last week was big from the Fed, the Federal Reserve. We had Fed Minutes on Wednesday. The Jackson Hole Symposium was on Friday. Which way you want to go with this? I mean you want to talk about a little bit about both of them? What were your main takeaways last week with the Fed and kind of how it relates to our investors sort of listening here?
John Lynch: Sure. I think the most important thing was Jackson Hole. Guys like you and I love reading the Fed minutes, but I know that that's not as popular for the average investor. The Jackson Hole speech was very important because new Fed Chair Jerome Powell, it was his first opportunity to speak at this illustrious conference. One that you and I failed to get an invite to yet again I should point out. I'm sure next year.
Ryan Detrick: Always next year.
John Lynch: That's right. We can always count on that next year. Jerome Powell, when he gave his speech, this is something we've talked about with our investors previously. I've joked to a degree about the fact that J Powell is the first Fed chair since Paul Volcker who's unburdened by the expectations of a PhD in economics. He's not focusing entirely on econometric models. He's an attorney. He has been in some regulatory aspects. He has on Wall Street. He had been in private equity. He's more of a market savvy Fed chair where I certainly believe we needed the econometric models during quantitative easing under Fed chair Bernanke and Fed chair Yellen.
I think having more of a market savvy type leader at the Fed right now will be terribly important because the yield curve is sending signals. The economy is sending signals, and the currency is sending signals that the Fed chair has to really be mindful of. The fact that Chair Powell on Friday in his speech talked about the gradual approach was perhaps more dovish than many anticipated. We think that's a benefit going forward.
Ryan Detrick: That's right. This week actually in our weekly economy commentary, John, we are going to write about just this, the Fed Minutes kind of takeaway and the Jackson Hole Symposium takeaway. I'm just going to read the last line of what we wrote here. We said, "Powell's approach is cautious and measured, which we believe greatly reduces the Fed's chances of a policy mistake." One other theme that we saw on Friday in his speech was the world flexibility. Again he doesn't seem like yes. Is there going to be one more rate hike in September. We all agree that's probably the case. Will there be one in December?
When you talk about as we did last week with the Turkey issues, merger market issues, maybe there won't be a fourth one. It doesn't seem like he's going to burdened by that because again he's using that flexibility. What do you think? There's one more in September we agreed. You think we'll get one in December?
John Lynch: September's a lock. It's about a 90% certainly in the Fed funds future market. Probably only about a 60% certainty for December. We'll come into the midterm elections. How strong the dollar is? What's the market reaction to the elections? What's the market reaction to Turkey? What's the market reaction to emerging market performance? I think that's something again, again not being burdened by a PhD in economics. Some of the things we need to keep in mind. The Fed's mandate officially by congress, is laid out by congress, is that they have to keep a lid on inflation and to basically ensure as full an unemployment situation as possible.
Yet a third assumed or presumed mandate unofficially is the currency, right? The Fed can't jack up rates too high that would make our dollar get too strong, which would negatively impact and we saw this over the past couple of weeks with Turkey. Turkey's a very small economy. Why did it make headlines? Well, because Turkey is running a current account deficit. Emerging markets by extension have $4.5 trillion in dollar denominated debt taken out over the past decade. If their currencies gets so weak that they have difficulty servicing $4.5 trillion denominated debt, that's something Powell wants to prevent.
In addition, you have to think about the humanitarian issue with food and energy costs. Food represents maybe 10% of our consumer pricing index in the West, but in the East, it represents more than a third. Powell can't really put emerging central bankers in a position where they have to raise rates to support their currencies so their people can eat. We have to be mindful of that, and I think Fed Chair Powell is.
Ryan Detrick: Very, very interesting dynamics for sure. There's one thing, John, I wanted to touch on. We talked about Jackson Hole, but from the Fed Minutes, I thought this was pretty powerful. This is directly from the Fed Minutes. "All participants pointed to the ongoing trade disagreements and proposed trade measures as an important source of uncertainty and risks." That sentence was the only recorded moment in the entire meeting that every single participant actually agreed on something. It's rare to see really anyone and everyone always agree, but clearly the trade concerns are something the Fed is actively paying attention to.
John Lynch: Yeah. It's rare to have unanimity in any policy meeting, but you certainly have that relative to trade. I think Fed officials are concerned, A, about the sentiment impact. They recognize what congress and fiscal legislators have financially begun to enact measures to run commensurate with historically low interest rates over the past decade. If you look at what tariffs would do for consumer purchasing power, business and investor sentiment, capex plans, it's certainly noteworthy to gain policy maker's attention.
Looking at the history in the late 1930s when Smoot–Hawley really was the death nail to any recovery, we had already seen a few policy mistakes with higher taxes. Fed raising interest rates too soon after The Great Depression and then Smoot–Hawley Tariffs, really that protectionist stance really extended the duration of The Great Depression. Consequently, I think market historians are very mindful of that. I suspect Fed Chair Powell is very aware of that. We don't believe that the Fed is going to be as aggressive as the market fears even with the yield curve.
Ryan Detrick: Right. When you talk about the yield curve, John, let's maybe go to rapid fire here where we're going to talk about the US dollar and the yield curve, how it all kind of relates. The US dollar. It plays a big impact clearly in earnings and specifically international earnings. I know you did a perspective provider on Twitter talking about this just last week. Well, what were your takeaways kind of on US dollar here and how it impacts things?
John Lynch: Yeah. I think on the dollar, we have to be mindful that it is the largest most liquid, supported by the most credit worthy government out there. You can't lose sight of as many term it King Dollar. There has been concern. The broadest measure of the dollar is the DXY. That's gone from 88 to 95 or 96 in recent months. We've seen a preponderance of articles related to a strong dollar. I wouldn't characterize a DXY of 95 as a strong dollar. 2,000 when the DXY was 120, that was a strong dollar in my estimation.
The dollar in our estimation now is simple less weak than it has been over the past decade, but nonetheless, the dollar has impact to multinationals whereby currency translation plays a big role when those dollars are converted back into profits domestically. That is one risk the Fed has to be mindful of, not raising rates so much that the dollar gets too strong that it can impact corporate profitability, but that clearly is not the Fed's concern. It's not corporate earnings that the Fed's concerned about. They have to be mindful of, if the dollar gets strong, that is good for inflation, right, because you're importing less inflation.
But the bigger issue I think has to do again on the humanitarian side, food and energy cost in the emerging world for six billion people, but also Fed Chair Powell does not want to cause an additional global financial crisis by the inability of emerging currencies to service debt on that $4.5 trillion. The dollar is very important. We questioned whether or not the Fed or Fed chair would acknowledge the dollar as a third mandate unofficially. He did not do that, but it seems like his actions are doing so. Then we also have to be mindful of the People's Bank of China. Over the weekend announced that they were going to have further support for the Yuan.
To the degree, that is less impactful to dollar strength. The Fed appears to be more dovish or less hawkish given Powell and some of the interviews we saw from Fed officials at Jackson Hole. Then if you think about just technically, the dollar, the DXY is facing resistance in that 96-97 area.
Ryan Detrick: You talked about what the Bank of China did over the weekend or is rumored to potentially doing. The initial reaction's good. I mean up over 2% their equity markets. Japan was up significantly also. We've talked a lot about emerging markets have been hit. Commodities have been hit. China obviously have struggled, but could. There's got to be a bottom potentially for China. That could be a positive for the overall global stock market really to have some more participation from the Far East.
John Lynch: Yes, absolutely. People can say the US has already won the trade war.
Ryan Detrick: Right.
John Lynch: It can be a victory when you think of all the damage going into it. I'm not convinced that's the case, but I do think ... Well, one thing we certainly know is that President Xi has a gig for life. We have a midterm election coming up in the better part of six weeks, eight weeks. Consequently, we may not see any true traction on tariffs with China until after the midterm election, but we're already seeing improvement with Mexico on NAFTA. Canada will likely rejoin the table once we clear something up with Mexico imminently it would appear. That's right.
Ryan Detrick: That's right.
John Lynch: Then we think that bodes well.
Ryan Detrick: Right. We had some new highs made last week.
John Lynch: I think certainly with the new highs and you were smiling. I wish we had this on video because anytime you see new highs, Ryan with his strategy hat and his technician hat, it's a double whammy when you think about how the market's performing. But yes, we did have new highs last week in the Russell. We had new highs in Russell 2000 small-cap index. We had it in the S&P 500. We had it in the Nasdaq, but we also had it in the Value Line, which is really the geekiest of those four indices. We did not see it in the DOW just yet, but the fact that you have an equal weighted index of 1,700 domestic companies at a new high I think is a very, very positive development.
Ryan, you've done exceptional work calling the next high in the market given all your work on the Advance-Decline Line and emphasizing prophetically how we were able to reach a new high. The fact that the equal weighted value line index reaching a new high I think is a very important development because that tells investors it's not just the largest and sexiest technology companies, right? It is a broader measure of performance when you think about that equal weighting. That says the average stock is doing well.
I think that we could also keep in mind, if you just want to look at that S&P 500, we're probably only four or 500 basis points above the 200-day moving average, which typically new highs are double that, right? We also have fewer companies making three month highs, even though we're at a record level. That also could be some tailwinds. What are your thoughts?
Ryan Detrick: That's right. You know, the way I like to look at this is the S&P finally made a new high for the first time since January 26 this year. Small caps in technology broke out back in May. There are a lot more small cap companies than there are large cap companies. The big argument we've heard and knocked on, we've heard on this bull market is only a few stocks are participating. The FANG stocks leading as higher. As we've been writing about and talking about for awhile, I don't think that's the case. The Advance-Decline Line is going higher. The small caps participating. Equal weighted technology indexes are also breaking out the new high.
That's one clue that we thought that yes, they'll eventually be new highs made the second half of this year, but so were there. Now that does it mean? We took a look, John, since 1950, there had been 18 times the S&P went six months or more without a new high after-
John Lynch: Over a six month period.
Ryan Detrick: Over a six month period. We just went seven months approximately. After that first new high was made, a year later, S&P was higher 17 of those 18 times. Up about 12.5% on average. It's one way to look at it, but sometimes you go awhile without a new high. It's just the market's way of consolidating. We gained 20% last year. We gained 5% in January. A seven month consolidation in my opinion is perfectly healthy and now we're at new highs. Maybe the bull will continue here.
John Lynch: You say that return is 12%-
Ryan Detrick: Just over 12% a year.
John Lynch: ... 12 months out, right?
Ryan Detrick: Yeah, exactly.
John Lynch: If you look at 8%, that's a 50% increase over historical-
Ryan Detrick: It is.
John Lynch: ... averages.
Ryan Detrick: It is stronger across the board. Three, six, nine months later, you get stronger returns when you go awhile, awhile isn't six months or more, without a new high. That's positive.
John Lynch: You've said many times never short a dull market, right? We have historical precedent where the economy can outperform the market. The curve can flatten. Profits can grow above historically average levels if you think about the mid-'80 example and the 1994-95 example, right, where you see the economy profits outperform the market while the curve flattened. The ensuing year, the following year, was up by about a third. We've got some historical precedent there in addition to your great work that we believe this thing still has legs.
Ryan Detrick: You talked about yield curve inverting. The 2-10 is kind of the bible that we use when you talk about the yield curve. It inverted back in January 2006 and yes, that was a warning sign there was recession coming, but there still were equity gains for another 18 months. History tells you you're going to have about 13 months or so after you see a yield curve inversion that you're going to have maybe potentiality 20-25% continued gains over those coming years and months. It's a concern. Nine of the last nine recessions all had an inverted an yield curve ahead of time. That's why we're watching it closely.
But when you look at profits continue to be strong, leading indices, and indexes continue to be strong, there's still a lot more positives we think. What do you think about the yield curve?
John Lynch: Nine of the last nine recessions had an inverted yield curve-
Ryan Detrick: Ahead of that.
John Lynch: ... prior to that, right?
Ryan Detrick: That is correct.
John Lynch: Nine of the past four recessions were actually predicted by economists, correct?
Ryan Detrick: That's right.
John Lynch: You never want to say it's different this time. When the Fed quintuples its balance sheet, there is a dynamic and global central banks have quintupled their balance sheets, there's a dynamic going on that at least fails to provide precedent. If we see the short end of the curve like we believe, the short end of the curve has been moving in anticipation of Fed activity, but we must be mindful of what's happening on the long end of the curve. There is a global valuation metric going on that we've not seen in previous examples.
I think that's more reflective of what the curve is telling us when global investors even when you factor in currency hedging costs, global investors can look at the 10-year approaching 3%. They can look at the Japanese Government Bond, the JGB, around three basis points, or they can buy the German Bund at 30 basis points. Suddenly the 10-year appears attractive to global investors even if we would consider it expensive relative to historical average cost for the 10-years. I think that's a dynamic going on that again Fed Chair Powell may use his market savvy to help him make and Fed leaders to make decisions going forward because we're not convinced it's pointing toward recession.
Ryan Detrick: Right. We've taken a look at kind of what happens when the 10-year yield is in an uptrend versus a downtrend in stocks. This is one of the I think the more misunderstood things investors have seen over the past couple of years really since June of 2016 when the 10-year yield bottom around 1.39%. Obviously it's gone higher since then. People think higher rates, higher 10-year is bad. We look back in history, there are 23 periods of a higher 10-year yield. The S&P gained during 19 of them. If my math is right, almost 90% of the time. Normally a higher trending 10-year yield is actually a good thing if the economic data can suggest it and support it.
If the 10-year breaks above 3%, as long as it doesn't just rocket higher to 4% or 5% quickly, potentially we could once again continue to see higher equities along with the higher 10-year yield.
John Lynch: Certainly you don't want to be dismissive of the risks, but when you have a flattening curve with rising interest rates, classic bear flattener for the bond geeks out there, that tends to be positive for equities.
Ryan Detrick: The last time we saw a bear flattener was in '94-'95 when you had the yield curve this low. That's another positive. John, I think we're kind of getting close to the end. I've got one more question for you.
John Lynch: Sure.
Ryan Detrick: I'm going up to Ohio this weekend for Labor Day. I have three weddings, Friday night, Saturday afternoon, and Sunday evening.
John Lynch: Are you getting married three times?
Ryan Detrick: No. I've been married once and that was plenty. I'm still married. I don't mean it like that.
John Lynch: Good. Good.
Ryan Detrick: But three weddings in three days. Think you'll ever see me again? Will I survive this weekend?
John Lynch: Well, we may have to cancel next week's podcast. I'm not sure.
Ryan Detrick: Find another guest.
John Lynch: That's right. Hopefully there won't be any video of you dancing at these three weddings.
Ryan Detrick: Oh, that's a problem with weddings anymore, right? Everyone's recording everything. I hope not. I hope not.
John Lynch: Ryan's going viral.
Ryan Detrick: That's right.
John Lynch: It should be a big week not only Ryan on the dance floor at three weddings, hopefully you won't pull a hammy, but we will see Core Personal Consumption Expenditure Index. I don't expect you all to be as excited about that as I am, but that is the Fed's leading inflation indicator. Be mindful that just because the Fed's leading preferred measure is at 2%, that is not runaway inflation. That is purely price stability. We'll get another consumer confidence near record levels. Cycle highs this week. I think that will be important as well. Ryan, I want to wish you a good week and safe travels. Well, that's it for this episode.
Join us next week where we'll continue to analyze and discuss market signals. Stay connected by following us on Twitter @LPL or @LPLResearch. LPL Market Signals is presented and produced by LPL Financial. I'm John Lynch.
Ryan Detrick: I'm Ryan Detrick. Thanks, everyone.