Most commentators have blamed the recent market turbulence on the Federal Reserve. Rising interest rates can spook investors. But stocks may be falling for another reason: profits.
The first quarter is coming to a close, and things are not looking so good. Analysts predict that, on average, earnings at companies in the S&P 500 for the first three months of the year have fallen 5% from a year ago, according to FactSet. That would be the first time profits at the biggest U.S. companies have declined since the third quarter of 2012, and the largest dip since the third quarter of 2009, when profits dropped nearly 16%.
For the year, analysts are predicting the profits of companies will rise, but only slightly, by 0.4%, according to estimates from Standard & Poor’s. That estimate is based on profits improving throughout the year, which would be a good thing. But analysts are often overly optimistic about the fourth quarter, particularly when it is still six months away. If the those end of the year predictions don’t pan out, then we could see a full year profit decline.
Stocks tend to follow profits, but they haven’t for a while. Profit growth dropped to 6% last year, from 8% in 2013. But that didn’t stop the market from rising 13% in 2014. That divergence has pushed the price-to-earnings ratio forthe S&P 500 to 17 times based on this year’s projected earnings, which is the highest it’s been in more than 10 years, and seems high for a market in which profits could soon be shrinking. The average p/e ratio for the past 10 years has been 14.
The good news is that the worst news is concentrated in one sector: energy. Exclude energy companies and profits for the S&P are expected to rise 3% this year. What’s more, the big banks are looking like they had a better than expected first quarter, which should push that number up further.
Still, the all-in number matters. Sam Stovall, chief strategist at S&P, says we may have already entered a so-called profit recession, and that would be a bad thing. Stovall says there have only been three instances since the end of World War II in which the S&P’s annual profit has fallen, and the rest of the economy hasn’t ended up in a recession. However, 2012 was one of them.
Add to that the fact that interest rates are set to rise, and there’s a lot of worrisome stuff that could be coming investors’ way this year. Indeed, if profits were rising, investors probably wouldn’t be as worried about the looming rate hikes. But the fact that profits are already stalling before interest rates have even started to climb will certainly make investors more nervous when rates do go up.
“The Fed may want to push rates higher, but that’s only going to make the dollar stronger, which will hurt profits more,” says Stovall. “The market has a lot of headwinds right now.”
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