US companies reported stellar first-quarter profits this year. But some investors suspect that earnings growth has plateaued. Our research suggests that slowing earnings growth means nothing for stock prices.
As earnings season draws to a close, the results look pretty spectacular. US companies posted earnings growth of 26%, with 91% of S&P 500 companies reporting as of May 10. Until last week, stock prices ignored the strong results.
Earnings Growth: A Red Herring
Investors may be worried that earnings growth has reached a crest. We think that’s a red herring. Our research shows that after three previous peaks in the US earnings growth rate since 1994, stocks continued to rise for several years (Display above). That’s because even when the rate of earnings growth slows, the absolute level of corporate profits typically continues to rise for a long time. In fact, when earnings growth was less than 10% a year, the S&P 500 still returned 9.4% a year on average (Display below).
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Yes, earnings growth is likely to slow. According to consensus analyst estimates, earnings growth will decelerate to 24% in the fourth quarter, and then to about 10% in 2019. But despite the dramatic slowdown in the growth rate, the absolute level of annualized earnings will still be around $185 by the fourth quarter of 2019 compared to $148 today—a 25% increase over the next 20 months. This implies a multiple of 14.5 times 4Q 2019 earnings for the S&P 500, which we think looks attractive, particularly compared to 18.2 times 1Q 2018 earnings.
Healthy Vital Signs Should Support Stocks
Of course, there are real risks to consider, and history may not repeat itself. Previous earnings peaks came very early in the economic cycle. Today, the economy is in its ninth year of recovery, while companies have also increased profits for nine straight years.
But US and global economic vital signs are still healthy, which should support stocks, in our view. Don’t pay too much attention to the rate of earnings growth. Instead, look for companies with strong fundamentals and resilient business models that can foster long-term profits—and stock returns—even if the market’s earnings growth starts to slow.
The views expressed herein do not constitute research, investment advice or trade recommendations and do not necessarily represent the views of all AB portfolio-management teams.