Dovish Fed – Not Earnings Growth – Key to Recent Stock Market Performance

The dovish stance of the Fed provided a strong boost to stock and fixed income markets in the first half of 2019. Off depressed fourth-quarter equity markets, the S&P 500 shot up over 17% in the first half. Over 90% of that positive stock market performance came from multiple expansion (see Figure 1), not earnings growth.

Figure 1

S&P Total Return Attribution

Earnings Expectations — 2019 Second Quarter

Second-quarter 2019 earnings reports will be cascading in over the next three weeks. Currently, analysts expect second-quarter earnings to decline by 2% (see Figure 2). However, in the prior first quarter, analyst forecasts also showed similar expectations for lower earnings. Despite their caution then, first-quarter earnings, in fact, showed a slight improvement.

Figure 2

Quarter 2 2019 S&P 500 Earnings Expectation

Earnings Outlook Remainder of 2019

The second half earnings outlook remains cloudy (see Figure 3). Beyond the uncertain earnings outlook, short-term stock market performance will likely respond to trade settlement headlines. While many will cite comments from government officials to speculate on a trade settlement, ultimately, that outcome will depend on two individuals — the Presidents of the United States and China.

Beyond the broad impact of trade uncertainties, probable economic slowing and the rolling down of last year’s tax cut benefits will likely pressure second-half earnings comparisons. As a reminder, in 2018, the tax bill added roughly 12% to net earnings growth.

Company guidance during their second-quarter earnings releases should provide an updated view of full-year earnings expectations. With roughly three-quarters of the S&P market-cap-weighted index reporting by the end of July, investors will quickly gain a good sense of earnings expectations for the full year.

Figure 3

Citi Earnings Revisions Index Vs S&P Index

Investment Conclusions

Based on the recent Congressional testimony of Federal Reserve Chair Powell, The Federal Open Market Committee seems almost certain to cut Fed Funds rates at its July 30-31 meetings. Financial markets continue to react favorably to these dovish policies. Ultimately, that optimism will face tests.

Some of the follow-up tests may be measured by whether the economy first avoids a downturn and then generates economic growth faster than its roughly 2% potential. An additional test will look to corporate earnings improving their current lackluster growth rates. On the other hand, accommodative monetary policies can do little to resolve the trade dispute — the key to rebuilding business optimism and faster economic growth.

In this uncertain economic mix, focus on quality companies marked by higher rates of returns on equity, low financial leverage, and steady earnings growth. Quality companies also exhibiting a pattern of raising dividends would add further to their attractiveness (see Figure 4). For fixed income, look to shorter-duration fixed income securities. If the Fed can stimulate the economy, faster economic growth would likely lead to higher interest rates—not favorable to longer duration debt securities.

Figure 4

Cumulative Monthly Returns of Dividend Paying Companies (1)

The Leuthold Group, At Each Quarter End, Formed Three Portfolios, 1) Companies Cutting Dividends (Grey Line); 2) Companies Raising Dividends (Dark Line); And, 3) Companies with Dividends Unchanged (Dotted Line). Cumulative Performance is Charted Based on Monthly Returns.