For much of the nine-year equity bull market, earnings growth has been the biggest contributor to gains — a fact that’s rung true for much of 2018.
Except in recent months, it’s been upward revisions to profit forecasts that have been doing the heavy lifting as analysts have modeled in the positive effect of the new GOP tax law.
They stem from the same idea: that stock prices are never more ripe for appreciation than when they’re generating good, old-fashioned bottom-line growth. Outside of the myriad macroeconomic factors that are constantly swirling, it’s as reliable an indicator as any when it comes to the health of the market.
Which is why it appears problematic that the three-month earnings revision ratio (ERR) for the S&P 500 fell in April for a second straight month, according to Bank of America Merrill Lynch data. While the decline is by no means an immediate death blow for the bull market, it suggests conditions are slowly deteriorating — and will only worsen.
Not so fast, says BAML. Sure, a declining ERR is troubling on a standalone basis, but the firm argues there are five drivers that should put investor minds at ease. They are as follows:
1) The 3-month ERR is still in the 95th percentile, relative to history— “We think a peak in the revision ratio is hardly a reason for concern,” Savita Subramanian, BAML’s chief US equity and quant strategist, wrote in a client note.
2) Almost all sectors are continuing to see more upward revisions than downward— The only sectors that aren’t include utilities, telecom, and real estate.
3) Historical precedence— The 3-month ERR peaked above 2 in March, and BAML notes 12-month total returns for the S&P 500 exceeded 8% following both prior instances.
4) Sales momentum is still strong— A measure similar to the ERR but involving sales, and referred to as SRR, is still near its highest level in 14 years. It’s also well above its long-term average, BAML says.
5) A continued pick-up in capital expenditures— The three-month ratio of above-consensus capital expenditure guidance to its below-consensus counterpart rose to the highest level in seven months. Why is that stock-accretive? Because investors are starting to favor companies that invest in themselves, according to Goldman Sachs.
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