The U.S. stock market is warning investors about earnings, and it’s time to pay attention.
The S&P 500 Index slipped into a correction on Dec. 7. It ended the day down 10.2 percent from its recent peak on Sep. 20, breaching the 10 percent decline that customarily marks a correction. The index is little changed this week through midday Friday.
Investors are comforting themselves, as they have all year, with reassurances about strong fundamentals. According to estimates compiled by Bloomberg, Wall Street analysts expect earnings for the S&P 500 to grow by 12 percent in 2018 and by an additional 9 percent in 2019. That’s well above the average growth rate of 4 percent a year since 1871, according to numbers compiled by Yale professor Robert Shiller.
It’s false comfort, however. As I pointed out in May, declines in the stock market most often precede slumps in earnings rather than the other way around. And this would be a particularly bad time for earnings to disappoint. Stock prices have rarely been as vulnerable to a downturn in earnings as they are today. If the market decides that the earnings outlook is too rosy, the recent sell-off could get a lot worse.
It’s time for investors to stop fighting the last war. The next downturn most likely won’t be triggered by another meltdown of the financial system.
The Federal Reserve has concluded its stress test of big banks, a look into whether they have enough money set aside to withstand another 2008-type financial crisis. The Fed announced last week that all 35 banks examined are sufficiently capitalized. It disclosedthe second and final round of results on Thursday afternoon, giving all but one bank a passing grade and the go-ahead to return money to shareholders.
Investors didn’t need the Fed to tell them that banks are in better shape than they were a decade ago. The signs are everywhere. Profits have fallen across the industry since the financial crisis, an indication that banks are taking on less risk. Profit margins for the S&P 500 Financials Index averaged 9.3 percent from 2008 to 2017, down from an average of 13.8 percent from 2003 to 2007, the years leading up to the crisis. Return on equity is down to an average of 5.2 percent from 14.5 percent over the same periods.
Jeremy Siegel has never lacked enthusiasm for the market.
Even nine years into one of the strongest stock market recoveries in history, “this bull market is not over yet,” said Siegel, who has been a University of Pennsylvania finance professor since 1976.
That should not come as a surprise. His 1994 book, “Stocks for the Long Run,” helped cement the conventional wisdom that stocks are a better bet for long-term investors than other popular investments such as bonds and gold.
Siegel’s timing couldn’t have been better. A year after his book appeared, U.S. stocks went on an epic run. The S&P 500 Index more than tripled from 1995 to 1999.