Earnings Could Be Stronger Than Ever; Growth And Small-Caps Time To Shine?

Written by LPL Financial

Fundamentals to drive stock market gains in 2018

With a focus on business fundamentals and the impact of fiscal policy, the return of the business cycle means that earnings growth may have to shoulder most, if not all, of the load if stocks are going to produce attractive returns in 2018.

The good news is the S&P 500 Index may be well positioned to generate earnings growth at or near double-digits in 2018 thanks to a combination of better economic growth and potentially lower corporate tax rates, despite some possible downward pressure on profit margins from higher wages.

We also expect the stock market’s price-to-earnings (PE) multiple, at 19.5 times trailing earnings, to hold steady (or drop slightly) in 2018, as the economic cycle ages, inflation picks up modestly, and central bank policy tightens further*.

Risks to our stock market forecast include Congress failing to pass a tax agreement (a low risk after Senate passage over the weekend), a potential policy mistake by a central bank, and political uncertainty around the midterm elections.

*The PE ratio (price-to-earnings ratio) is a measure of the price paid for a share relative to the annual net income or profit earned by the firm per share. It is a financial ratio used for valuation: a higher PE ratio means that investors are paying more for each unit of net income, so the stock is more expensive compared to one with a lower PE ratio.

Earnings Could Be Stronger Than Ever

After three straight years (2014–2016) of basically flat S&P 500 operating earnings, at around $118 per share, consensus estimates project $131 earnings per share (EPS) for 2017 and $146 per share for 2018. Earnings are supported by better global economic growth, including a pickup in business spending and robust manufacturing activity, normalized inflation (near 2%), and stable operating margins, even with some modest wage and other input cost pressures.

Should tax reform, or even just a lowered corporate tax rate, be achieved, earnings may get another 5–6% boost on top of that, putting numbers above the consensus $146 per share potentially in play. To break that down, a favorable macroeconomic backdrop supports mid- to high-single-digit earnings gains in the next year, consistent with long-term trends, resulting in our forecast of 8–10% growth, or roughly $142–143 for S&P 500 EPS for 2018 [Figure 1]. Our forecast does not include any direct impact from the tax bill because passage is not assured at this time (although likely) and final details remain unclear. We would identify earnings growth in the 13–16% range as the upside potential we may see from tax reform.