Stock markets are setting records but profits, tax cuts, cheap debt, buybacks and the Fed’s patience won’t last

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  • The S&P 500 and Nasdaq closed at all-time highs on Tuesday, but a stock-market rally driven by record profits, tax cuts, stock buybacks and loose monetary policy could prove to be short-lived.
  • First-quarter profits are expected to shrink, US earnings have outpaced gains in other countries, the Fed could still raise rates, and buybacks could dry up.
  • The proportion of lossmaking companies filing for IPOs has reached dot-com-bubble levels, and market volatility has hit record lows, suggesting markets may be complacent.
  • “Many investors seem comfortable that, with the Fed on hold, US corporates can merrily carry on issuing BBB debt and buying back stock. We disagree,” says one analyst at Bernstein.
  • Watch the S&P 500 and Nasdaq trade live.

The S&P 500 and Nasdaq closed at all-time highs on Tuesday, but a US stock-market rally driven by record profits, tax cuts, stock buybacks and cautious monetary policy could prove to be short-lived.

America’s benchmark index rose 0.9% to nearly 2,934, while the tech-heavy Nasdaq climbed 1.3% to about 8,120 – surpassing their previous record closes in the third quarter of 2018. The pair have registered gains of 17% and 22% respectively this year – their best first-quarter performances in more than 25 years, according to the Wall Street Journal – while the Dow Jones has gained 14%.

There are several reasons to doubt these breathless highs will continue.

Analysts expect S&P 500 profits to shrink 3.3% year-on-year, the worst first quarter since 2016

The biggest driver of US stocks has been profits. Earnings beats by Twitter, Coca-Cola, Hasbro and others were the catalysts for the market’s gains this week. More than 78% of the 100-odd S&P 500 companies that have reported earnings so far this season have bested Wall Street forecasts, compared with 69% overall last quarter, according to FactSet data cited by the Wall Street Journal. Yet analysts still expect S&P 500 profits to shrink 3.3% year-on-year, which would be the index’s worst first quarter since 2016.

Outsized gains for American stocks “rather look like US exceptionalism at work,” wrote Neil Wilson, chief market analyst for Markets.com, in a research note.

“S&P 500 earnings are set for a year-on-year decline – hardly the time for record highs on the stock market.”

Taking a longer view, earnings per share for US equities have risen 80% since the beginning of 2008, surpassing gains in Europe and emerging markets, according to Factset data cited by the Wall Street Journal. Bolstered by the Trump administration’s tax cuts, after-tax corporate profits now amount to 10% of national output, up from 6% to 8% during the second half of the 20th century. Further increases relative to the size of the economy would be unprecedented.

“The Fed has thrown in the towel but … markets have mis-priced the likelihood of another volte-face”

A key reason for the recent rally has been the Federal Reserve’s “patient approach” – the central bank isn’t expected to raise interest rates until at least the end of next year, according to a Reuters poll of economists. However, it may take more than a continued lack of action to push stocks higher, and rates could still rise.

“The Fed has thrown in the towel but … markets have mis-priced the likelihood of another volte-face by policymakers as they parse incoming data over the summer,” Wilson wrote.

Another factor has been stock repurchases, which boost earnings per share. “US equities are highly dependent on buybacks,” Bernstein analyst Inigo Fraser-Jenkins and his team wrote in a recent note on global quantitative strategy, adding that American companies promised $1 trillion of buybacks in 2018.

“Many investors seem comfortable that, with the Fed on hold, US corporates can merrily carry on issuing BBB debt and buying back stock. We disagree.”

“Many investors seem comfortable that, with the Fed on hold, US corporates can merrily carry on issuing BBB debt and buying back stock. We disagree. The low quality of US corporate debt plus a slowing in growth, we think, leads to rising credit spreads over the next 12 months which in turn put the kibosh on buybacks.”

Robust economic data has also bolstered sentiment and lifted US stocks. Retail sales leapt 1.6% in March, besting forecasts of 0.9% and reversing a 0.2% decline in February. The US economy also added 196,000 jobs in March, a sharp rise from the 33,000 added in February. There’s no guarantee the surprise recovery will continue.

One clear red flag is the raft of loss-making companies joining public markets. Last year, 81% of US companies were unprofitable in the year leading up to their public offerings, according to Jay Ritter, a finance professor and specialist in IPOs at the University of Florida. That proportion was last seen in 2000, just before the dot-com bubble burst and sparked a recession, according to Recode.

The VIX fell 10%

There are other signs of exuberance and complacency. The VIX, which measures volatility expectations, recorded its worst-ever performance last quarter and has fallen 10% this month, according to the Wall Street Journal.

Wary of getting carried away, some investors are hedging their bets. An increase in short positions in the market “shows that smart money is ready to bank big if the market falls again,” said Naeem Aslam, chief market analyst at TF Global Markets, in a research note.

It “makes absolute sense to buy volatility at its record low levels,” he continued, adding that “it would be a smart idea to have some insurance while one maintains [a] bullish view.”

Earnings beats, stock-market records and economic recovery are all well and good, but savvy investors will have a chair to sit on when the music stops.