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What Bubble? Strong Second-Quarter Earnings Season Deflates Fears

Stocks are by no means cheap, but strong earnings growth proves they're not wildly overpriced either.


Stocks keep notching new all-time highs, but despite certain market pundits’ fears, equities don’t look bubbly when considering this encouraging second-quarter earnings season.

gold bubble
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After all, earnings reports are now almost all wrapped up, and profits for S&P 500 companies expanded at the fastest rate in years.

Second-quarter earnings should finish 8.4% higher year-over-year, according to data from Thomson Reuters. And if you exclude poor results from Citigroup (C), the growth rate rises to 10.1%.

On the downside, those strong earnings were once again helped by cost cuts as much as sales growth. S&P 500 revenues increased 4.6% in the second-quarter. And although a large percentage of companies exceed analysts’ revenue estimates, in aggregate, S&P 500 revenue beat estimates by only 1%.

The bottom line, however, was a different matter, where solid growth leaves the forward price-to-earnings ratio on the S&P 500 at just 15.4, according to Thomson Reuters.

No, stocks aren’t cheap … but neither are they near the forward P/E’s we see when the market is in a bubble.

Sure, it’s easy to make the case that stocks are overvalued, but that means they’re priced for disappointing future returns, not necessarily that they’re bubbly. The current forward 12-month P/E ratio is above both the five-year average of 13.3 and the 10-year average of 13.8.

On the other hand, FactSet points out that the forward P/E on the S&P 500 is below the 15-year average of 15.8. More importantly, the valuation is well below levels associated with bubbles, where it climbs to 20 and above.

True, forward P/E is based on analysts’ estimates … and they’re always too optimistic just before everything turns south. But don’t forget that these same analysts have been too pessimistic for years. When they forecast record-breaking earnings for the next 12 months, they’re just as likely to be under the actual figures.

Wall Street certainly was too pessimistic coming into second-quarter earnings season. The projected growth rate for second-quarter earnings reports was 5.1% back in early July.

Wall Street Pessimism Revealed by Earnings Season Beat Rate

Furthermore, a better-than-usual percentage of companies beat Street estimates, and they did so by a decent margin. The long-term average beat rate is 63%, according to Thomson Reuters. More recently, over the last four quarters, the average beat rate for the last four quarters is 67%.

But in the second quarter, 68% of S&P 500 companies exceeded analysts’ estimates, and as a whole, they beat Street estimates by 3% — in line with the long-term average going back to 1994. That’s also the same upside surprise percentage seen in the last four quarters.

Of course, not all sectors enjoyed growth in Q2 earnings.

Financials, in the aggregate, saw earnings retreat by 6.5%, hurt by slowdowns in trading and the mortgage market, as well as tough comparisons against last year’s Q2. Appropriately, the Financial SPDR (XLF) exchange-traded fund is up less than 7% on the year, trailing the broader market by more than a percentage point.

On the other side of the ledger, the healthcare sector posted second-quarter earnings growth of more than 18%. At the same time, the Health Care SPDR (XLV) is up about 15% year-to-date. That doesn’t seem irrationally exuberant given the sector’s earnings growth.

Bottom Line

No, the strong second-quarter showing doesn’t prove there’s no reason to worry that the market is in a bubble. But the actual and projected earnings growth rates sure don’t support that argument.

Stocks are definitely pricey at current levels, but based on corporate earnings, they have a way to go before they’re wildly overpriced.

As of this writing, Dan Burrows did not hold a position in any of the aforementioned securities.

Article printed from InvestorPlace Media,

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