Why stocks will soar to record heights in the second half of 2018

The bull market is alive and well, and like it or not, the recent run-up in stock prices are far from over. The overall strength in both earnings and US economic growth is to hard ignore or deny. Meanwhile, fears of rampant inflation taking hold or soaring interest rates are more of fantasy than reality. 

One needs not look any further than the current trends in the earnings growth of the past year. In fact, the S&P 500 valuation is cheaper today than at the of the start of 2018, despite rising by roughly 6%. 

Strong Earnings Growth

The trends for earnings growth are too hard to deny with more than 62% of the companies that make up the S&P 500 already reporting results. Through July 31, nearly, 80.3% of companies have topped earnings estimates, while 13% have missed, and 6.35% have met, according to data from S&PDow Jones Indices.

In fact, the number of companies beating earnings estimates has now expanded for the 5th quarter in a row, rising from just 70% in the second-quarter of 2017. Meanwhile, the number of companies missing estimates have fallen from 9.74% in the second-quarter of 2017. 

Operating earnings have continued to climb for 2018 and 2019 as a result of the better than expected quarterly results. Despite the S&P 500 rising roughly 6% this year, the S&P 500 is cheaper today than it was on December 31, trading at 16 times 2019 operating earnings estimates vs. 16.7 times in December. That is because earnings estimates have increased by about 10.3% since the end of December. Not only that but operating earnings are expected to climb by nearly 11.7% in 2019 versus 2018. 

Strong Revenue Growth

The growth story for stocks in 2018 is not just earnings based. Revenue growth has been robust for the past several quarters. At the second-quarter current pace, S&P Dow Jones estimates revenue to rise by roughly 10.25% in the second quarter of 2018 versus 2017.

Sectors Are Cheaps

When looking at the sectors within the S&P 500,  with the exclusion of energy and real estate, they are all trading at that cheapest valuation since 2016, based on 2019 earnings estimates.  

Strong Sector Growth

Most of the groups are expected to see significant earnings growth continue into 2019, although at a more modest pace as the benefits of the US tax reform work off. But the rates of growth are still respectable.

Hard To Ignore

While some try to paint a bearish picture of the equity market, suggesting that current valuation are excessive, when digging deeper into the numbers, it is hard to find that narrative. It would seem to be much easier to tell a story of a stock market that undervalued given the strong earnings growth, big earnings beats, strong sales growth while trading at cheaper valuations today than at the start of the year.

Strong Economic Growth

The strong earnings and revenue growth does not live in a vacuum. US economic growth continues to remain strong as well, with Atlanta Fed’s GDPNow in the early days of the third quarter tracking around 4.4% as of 3 August. The robust estimates for the third-quarter follow a preliminary reading of second-quarter GDP growth around 4.1%.

Atlanta Fed

Inflation Outlook is Tame

The Fed’s preferred measured of inflation; the Trimmed Mean PCE continues to track just below 2%.

Inflationary pressure may ease in the coming months as the price of oil has declined since the end of June. That may help to reduce inflation fears in the producer price index (PPI) reading. The PPI and the price of oil have a very tight correlation going back many years, and the recent drop in oil prices should help to reduce the July PPI reading. 

The Speed of Money

The velocity of MZM, which is the ratio of GDP divided by MZM money supply, continues to remain flat, which also suggests inflation rate shall remain low, while longer-term Treasury yield should remain low into the future. The correlation between the inflation and Treasury rates are tight, and the velocity of MZM has acted as a leading indicator of inflation and interest rates in the past. 

The Bullish Narrative

With inflation contained and a lid on longer-term interest rates, the economy should continue to be robust over the longer-term, and that should help earnings and revenues for equities continue to advance, helping to fuel a further rise in the equity market.

Additionally, the market is trading a relatively cheap valuation on a historical basis when looking at earnings, estimates, while the continuation of low-interest rate should allow for further multiple expansion of earnings. 

At this point, the equity market appears to be primed to continue to rise over the short-to-medium term. 

The S&P 500 is currently cheap at current levels, and based on strong earnings growth is likely to see significant upside in the second-half of 2019.