The last several months have brought a barrage of unsettling news reports: the continual churning of Special Prosecutor Mueller’s investigation of alleged “Russian Collusion”, tariff tit-for-tat between the U.S. and China, American bombing of Syria. Some of these have caused jitters in the markets, but the one thing that gets very little press is the thing to which investors should be most attentive: a surge in corporate earnings.
Many factors can contribute to short term “squiggles” in market indexes, but longer term trends in markets and individual company stocks are driven by the prospects for future earnings. When a stock’s value goes up or down on news, it is because investors are using their investment money to voice their optimism, or lack thereof, over its earnings potential.
Strongly positive earnings picture
In an April 13 story in Barron’s, Jack Hough reports that first quarter 2018 earnings reports are expected to be strong, and that this year looks to be the best year for earnings since 2010. The markets have needed positive news, given the blizzard of disquieting reports from Washington. Positive earnings is the news that really counts, more so than what happens with President Trump’s personal lawyer or cruise missiles hurled at a middle east dictator.
The S&P is 7 percent cheaper, relative to earnings, than it was at the start of 2018. Energy companies are getting a boost due to rising oil prices. Tax cuts are giving companies more money to invest into projects that can grow the business. But the Barron’s article says that even adjusting for these factors, earnings are positive across the board. The top five sectors seeing growth are energy, financials such as banking, materials producers, industrials and information technology. Already, several major banks have reported strong earnings.
WD-40, the ubiquitous silicone lubricant found in garages nationwide, is investing a million dollars of found money in additional marketing for its product. As corporations reinvest tax savings, jobs are created, consumers spend more in the economy and the entire economic pie grows.
This is a lesson that liberal economists and politicians never seem to learn. They see taxes as a zero sum game and if tax rates are cut, in their thinking, revenue to sacred government programs will suffer. The truth is that tax cuts grow the entire economic pie, increasing tax revenue as companies and consumers benefit. As one financial analyst put it:
Happier headlines are on the way, offering relief for the stalled bull market—at least for now. “We’re looking ahead at six, maybe eight quarters of earnings momentum,” says John Lynch, chief investment strategist at LPL Financial, a broker-dealer serving independent financial advisors. “Companies are going to invest some of the extra cash from tax cuts, and consumers are going to spend.”
The core versus the short term effects
Hough goes on to say that the challenge for investors will be to discern what really matters in the long run, and to separate out short term benefits. He gives examples:
Credit Suisse estimates that lower tax rates will add seven percentage points to growth in the first quarter. So if the Street is expecting 18% growth, the core trend is more like 11%. Energy has the highest expected earnings growth of any sector—79% for the first quarter. That’s enough to contribute about two percentage points to S&P 500 earnings growth. Some of that energy jackpot is owed to rising oil prices; Texas crude fetched $65 a barrel at the end of March, versus $51 a year earlier. So trim another percentage point or so, leaving core growth closer to 10%.
Another factor producing longer term optimism is the lightening of regulatory burdens by the Trump Administration. The high cost of regulation is another factor that liberals overlook, pooh-poohing the deleterious effect it has on the ability of businesses to prosper. But money spent satisfying regulators is money not available for research into new products, improvement of manufacturing equipment and other, more productive uses. Lightening the regulatory load frees up capital for growing business.
Government debt could undo it all
Looming in the background are two long term factors that could make the rosy earnings picture darker: soaring government debt and the threat of rising inflation.
Let’s start with inflation. During the Great Recession of 2008-09, the Federal Reserve pumped $4.5 trillion in new money into the economy to prevent a deflationary crash. Now the economy is stirring to life after nine years of languid economic growth, but that spark could ignite that ocean of money into punishing inflation, 1970s style.
By 2020 government deficits are projected to top $1 trillion per year. Taxes will have to be raised, because politicians will be loath to cut any programs that could cost votes. But taxes cannot be raised enough to cover such massive shortfalls, so, as Jerry has pointed out, the inflation that is headed our way will be the government’s answer to paying down its debt, using inflated, worthless dollars.
This is why it is important listen each week to Jerry Tuma’s Smart Money Radio and to access past shows on the Cornerstone website.
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