The stock market finished the first half of 2019 on a strong note. The S&P 500 stock index has risen 17% this year, its best first half of the year since 1997. Interestingly, virtually all the gain was from a change in valuation (rising price/earnings multiple) as earnings growth in the first quarter was quite modest.
One of the primary reasons for slower earnings growth is a surplus of capacity worldwide. Sellers with excess capacity lack pricing power, which typically happens when supply exceeds demand. Raising costs (e.g. tariffs) during periods of oversupply suppresses economic activity. That is why worldwide trade volumes are down and why profit margins are getting squeezed.
Tariffs undo much of the good from the cuts in corporate tax rates. Corporate earnings, which earlier this year looked like they could rise 7-10%, now look likely to be up 0-5% for the year. The reason stock prices are up isn't about expanded sales and earnings. It's all about lower interest rates and higher P/Es.
With stocks now back to all-time highs, the risk of lower future returns is rising. To move ahead further, either earnings prospects must improve, or interest rates have to fall further. Starting next week, investors’ focus will be on second quarter earnings. Current consensus estimates for S&P 500 operating earnings are $40.44, up 3.3% from the first quarter’s $39.15. Any major positive or negative surprises will likely move the market in that direction.
Craig A. Vander Molen, CFA, CPWA ®
Managing Director and Chief Market Strategist
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