Why corporate profits matter to stock investors

Russel Price, Senior Economist, Ameriprise Financial

November 2018

  • Profit growth is a central driver of stock market performance.
  • Earnings growth has been robust, but headwinds are forming.
  • The pace of earnings growth is likely to slow, yet remain positive.

Corporate profits, also referred to as earnings, have been a strong source of support for the stock market this year. In the first two quarters of the year, companies that make up the S&P 500 reported exceptional year-over-year earnings per share (EPS) growth of 25%. According to the market data firm FactSet, when combined with estimates for the second half, S&P 500® Index EPS are projected to rise approximately 22% this year, surpassing even the above-average growth we saw in 2017 of +11.6%.

Profits set the stage for market direction

There is perhaps no greater driver of stock prices than the level and growth rate of corporate profits. As profits rise, the value of the underlying company grows, thus lifting the value of each outstanding share.

It’s understandable, then, why stocks have continued to move higher this year despite rising trade tensions and Federal Reserve interest rate hikes.

There is perhaps no greater driver of stock prices than the level and growth rate of corporate profits.

Over time, stock prices should rise at a pace that is generally similar to that of earnings. From 1926 to 2017, the S&P 500 Index1 posted average annual growth of approximately 10%, according to historical research in the Duff & Phelps SBBI Yearbook. These results were supported by EPS growth of approximately 8%, while an average dividend yield of about 2% accounted for the remainder.

The earnings boom of 2018

Tax cuts passed by Congress in the closing days of 2017 have been a significant contributor to this year’s strong profit growth. The Tax Cuts and Jobs Act of 2017 lowered the U.S. corporate tax rate to 21% (effective Jan. 1, 2018) from 35%, along with other adjustments. We estimate the lower rate has accounted for approximately one-third to one-half of this year’s S&P 500 earnings gains.

Strong economic growth and favorable business conditions have played an equally important role. Sales growth, which is unaffected by tax rate adjustments, was 10% higher year-over-year in the second quarter this year, much stronger than the long-term historical average sales growth rate for S&P 500 companies, which is approximately 6%.

The challenge: sustaining the pace

The pace of profit expansion, however, is likely to slow in the months ahead. Most prominently, the tax cut benefit will lapse in 2019 when measured against prior-year results.

Also, multinational companies based in the U.S. that sell their wares abroad posted some of the strongest earnings gains for the first half of this year. That may change as we move forward. Economic expansion in some major foreign markets seems to be moderating, and multinational companies are most susceptible to the impact of tariffs or other trade-related disruptions that could emerge.

The U.S. dollar is also gaining strength compared to other major currencies such as the euro, Europe’s common currency. When the dollar strengthens, sales and profits generated in foreign currencies convert into fewer U.S. dollars for financial reporting purposes. In 2017, approximately 44% of S&P 500 company sales were generated outside the U.S., according to S&P Global. As such, a stronger dollar could detract from earnings growth over the next few quarters at least.

Such challenges, however, are unlikely to fully offset what are still strong underlying business conditions. Currently, analyst consensus estimates for 2019, as compiled by FactSet, show S&P 500 earnings per share expanding by +9.5%. This assumes that the economy continues to grow in 2019, which is our general expectation.

Slower growth leaves less room for error

Earnings expectations, however, could also be overly optimistic. A serious escalation of U.S. / China tensions, or the unintentional slowing of the economy spurred on by too many Federal Reserve interest rate hikes, currently stand as the greatest threats to the intermediate-term outlook, in our opinion. Nevertheless, we believe the current U.S. economic expansion, now in its tenth year, still has room to run as consumer finances remain relatively strong.

Although we believe corporate earnings growth has likely seen its near-term peak, a return to more normalized rates should not hinder the prospects for a continued bull market in stocks, in our opinion. Amid this transition, however, you should talk with your advisor to determine if your investments are appropriately allocated given the potential for shifting risks and opportunities.