The S&P 500 remains in a bull market, despite fears that tariffs would derail economic growth. A temporary delay in tariff implementation created a floor under the stock market on April 9th. Continuity believes that strong earnings reports are what led the S&P 500 to set a new closing high on September 4th.
With almost all the S&P 500 companies reporting as of September 5th, it can be said that the second quarter’s reports have been strong absolutely and relatively. Sales grew an impressive 6.25%, leading to earnings growth of 12.61% (source: Bloomberg). Additionally, sales surprised 2.08% while earnings rose 7.60% more than analysts’ projections. Ten of the eleven GICS sectors’ earnings exceeded expectations. The one sector that did not was the materials sector where earnings declined 2.60% and were 0.13% below expectations (source: Bloomberg).
In the long run, earnings and cash flow determine which stocks or sectors prosper, and which ones lag. Therefore, Continuity does not think it should come as a surprise that the information technology and communication services sectors, two sectors that have led this secular bull market, showed the best earnings growth during the quarter (source: Bloomberg).
The information technology sector’s earnings grew 22.66% while the communication services sector saw earnings rise 44.07%. Financial stocks outperformed through August, and this was reflected in corporate reports. The sector saw earnings rise 16.21% compared to a more modest 4.39% growth in revenues on the heels of impressive margin expansion (source: Bloomberg).
Most economically sensitive sectors showed strong earnings growth and share performance. The one exception was the industrials sector. Despite being the second-best performing S&P 500 sector through August (source: Bloomberg), its revenues only grew 4.06%, less than the S&P 500, while earnings rose a mere 2.07%.
The weakness was not due solely to one-time items. Twenty-one of the seventy-two industrial stocks in the S&P 500 saw their earnings shrink during the quarter. Continuity believes that investors are betting that the administration’s focus on domestic manufacturing will benefit the sector. We think earnings will need to catch up with the stock price moves for the sector to continue to outperform.
At least through July, investors that were worried about the effects of tariffs on sales and margins had little evidence that those fears were realized on most companies’ income statements. While the second quarter reports were good, there is no guarantee future reports will impress investors. Tariffs are just starting to bleed into the economy, and many companies and consumers tried to get ahead of them by purchasing goods before they went into effect.
Nevertheless, second quarter earnings reports have been good absolutely and better than expected. We believe a continuation of this trend is one condition required for the strength in U.S. large capitalization stocks to continue. Inflation, unemployment, and the Federal Reserve’s reaction to incoming data are risks that could ignite a pullback.
Our bigger concern is that with the S&P 500 priced at 22.8 forward earnings estimates (source: Bloomberg), strong earnings growth is needed in the coming quarters. If not, a pullback is likely. Continuity will remain alert for indications of a deterioration in corporate fundamentals. Until then, investors can take solace in corporate reports which were strong in aggregate.