Earnings Growth Supports Stocks: The Forward Multiple Has Compressed

Global Earnings Drive Growth

If an analyst states “the fundamentals are sound” on financial T.V. during a correction, he/she gets mocked because the fundamentals have no relationship to the near term trading action. However, it is an important assertion because if the fundamentals are sound, the selling will be limited. If the fundamentals aren’t sound, the correction will turn into a bear market. Part of the reason these analysts get mocked is because there’s always someone saying the fundamentals are sound. Even before the financial crisis, there were analysts downplaying the negative catalysts. They said housing was only a small part of the economy. Obviously, the home builders and real estate agents are a small portion of the economy, but elevated default rates hurt banks and borrowers.

This time, the fundamentals are sound which means the current correction probably won’t get much worse than down 15%. My basic understanding of technical analysis says stocks might retest the lows before rallying again; it seems like the correction is almost over. The chart below shows the fundamentals are principally boosted by earnings growth from international firms. This means tech is doing well because the sector has a large international presence. As you can see, the firms with over 50% of their sales coming from international markets have greater sales growth and margin growth. Their earnings growth is 17.4% which is much higher than the 12% growth from firms with less than half of their sales coming from international markets. The tax cut is supposed to help domestically oriented firms, but the repatriation holiday also helps international firms. Therefore, this relationship should continue in Q1 2018.

Stocks Are Much Cheaper Now

The fastest way for the forward earnings multiple to decline is if expected earnings increase and stock prices fall. That’s what has been happening in the past couple weeks. This is a sharp reversal from what we have seen in the past couple of years when either stocks were going up faster their earnings growth or stocks were stagnant and earnings growth was negative. The chart below shows the recent changes in 2018 and 2019 earnings estimates.