Are stocks overvalued? Unusually strong earnings may justify sky-high valuations

Great expectations.
Great expectations.
Image: Wikimedia/Rafael Matsunaga
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Equity analysts are an optimistic bunch. When they forecast future corporate earnings, they tend to start out bullish. But as time goes on, and reality sets in, those estimates get more subdued.

Until this year.

For months, analysts have penciled in double-digit growth in earnings per share for the S&P 500 in 2017. Similarly bullish expectations for earlier years’ earnings were dashed by now. What’s more, of the 91% of S&P 500 companies that have reported profits for the second quarter thus far, more than 70% beat expectations.

Robust earnings is one of the main justifications for US stocks’ historically high valuations. That said, there are plenty of market players who fear that markets may be in bubble territory. Nearly half of fund managers recently surveyed by Bank of America Merrill Lynch said that stocks are overvalued, the largest share since the poll began in the 1990s.

That said, there are fundamental economic reasons boosting corporate earnings this year (and beyond). Many S&P 500 companies are global, with a large share of their revenue generated outside the US. With a weakening US dollar and a strengthening global economy, companies with global exposure are set up well. In the second quarter, earnings growth for companies with less than 50% of sales in the US was 14%, almost double the growth of largely domestic companies, according to FactSet (pdf).

The Federal Reserve’s raising of interest rates also factors into earnings forecasts. Anxiety over when the Fed will hike rates can reduce expectations if analysts believe the economy isn’t ready for anything besides close-to-zero rates. This may have played into projections for earlier years. But now, with three rate hikes since late 2015, Fed chairman Janet Yellen has made it clear that future hikes will be gradual.

But one sign that markets may not rise much higher, despite strong earnings, is that the companies reporting better-than-expected profits this year saw an average 0.3% fall in their share prices immediately after, per FactSet. Over the past five years, companies with positive earnings reports saw, on average, a 1.4% gain in their share prices. Recent jitters on terrorism fears, geopolitical tensions, and turmoil in the Trump administration also suggest that earnings are not the only thing driving investment decisions these days.