Recently, my wife and I went to try a newly opened restaurant in our town. The previews and fanfare had us counting down the days until our reservation. Yet, on our ride home we felt a bit disappointed and couldn't quite figure out why. Maybe it wasn't that the meal was bad, but that our expectations were set too high.

The stock market is having a similar reaction to first quarter earnings season. There has been a lot of hype about the extra earnings lift that corporations would see as a result of tax reform, with estimates increasing as the season progressed. Companies have topped estimates, generating earnings growth of nearly 25%, but the stock market has spent much of earnings season on a road to nowhere. It wasn't until recently that stocks trended higher, but we believe this is probably based on other factors, such as more benign inflation figures and progress made in the trade arena. Still, many investors are asking why the market isn't rewarding earnings growth to the degree expected. What gives?

Good News Priced In

Equity markets are forward looking and thus, the strong equity market returns of 2017 were a precursor to the lift to corporate earnings in the first quarter of this year. In fact, that optimism lasted until January 26, 2018, at which time the market shifted its attention to potential issues that could derail this bull market, namely inflation. The list of worries has gotten longer since late January and now include trade tensions with China, instability on the Korean Peninsula, the potential regulation of certain technology companies, the Mueller investigation and the U.S. withdrawal from the Iran nuclear deal.

Then, earnings season arrives with the promise of shifting attention to fundamentals. Corporate fundamentals are proving to be strong, with 78% of S&P 500 companies that have reported beating estimates. According to FactSet, the latest tally shows the blended, year-over-year earnings growth rate for the first quarter now at 24.9%. In addition to solid bottom-line growth, sales are up 8.2%. However, these healthy results haven't been enough to push equities decisively higher. Companies that have topped earnings estimates have not been rewarded as we've seen share-price gains of just 0.2% two days before the earnings release through two days after reporting, well below the typical average increase of 1.1% over the past five years. Earnings misses have also been punished to a greater degree than we've seen over the same five-year period. In spite of these reactions to earnings the market has remained resilient, as it has been able to recover from intraday pullbacks. This shows that there are investors more than willing to step in and buy equities at even slightly lower prices.

The Peak Earnings Debate

There is understandably some anxiety over whether earnings have peaked and if this means that this might actually be the end of the bull market. If you look at history, as I often do, there are 15 instances where S&P earnings per share (EPS) growth has been greater than 2018's expected growth of 19%. As illustrated in Exhibit 1, in 11 of the 15 instances, the market return was positive the following year. In those instances when market performance was negative, many were the result of external events ranging from the preparation for World War II to oil price spikes. While one can never anticipate a future shock, it does seem that history is on the side of a continued move higher in equities.

Exhibit 1. Historically High Earnings Growth

In fact, economic fundamentals look quite strong both at home and around the world. Our theme of synchronized global growth is still intact. Recent economic data suggests that the U.S. economy remains healthy, with first quarter gross domestic product coming in at an annualized rate of 2.3%. The labor market remains strong as well. Unemployment is at multiyear lows and wage inflation remains contained. Importantly, the Federal Reserve appears comfortable with its strong U.S. growth outlook and has indicated its intent to remain data-dependent and measured in its approach to monetary tightening.

I continue to believe that stocks have room to move higher. The market is actually healthier now than at the beginning of the year — the underlying foundation supported by higher earnings and lower multiples. There is a strong likelihood that the market hasn't fully priced in the positive effects of tax reform. Certainly, the tax cut created one-time benefits to earnings that will not be repeated in 2019. However, the net effects of a major reform to the tax code will not be fully realized this year as policy lags are notoriously long and variable. The withholding tables for paychecks were only changed two months ago and the supply-side, or "capex," effects of the reforms have barely had time to be implemented. So although the level of earnings growth may not be repeated, we do expect positive earnings growth for the rest of 2018 and 2019.

Markets Will Eventually Reward Earnings

Markets have, in fact, moved higher in the past couple of weeks, breaking out of the sideways trend of the last few months. There's been a plethora of headline news and market distractions: trade negotiations with NAFTA partners and China, geopolitical risks on the Korean peninsula and the Middle East, higher oil prices and the U.S. midterm elections to name a few. Despite this uncertainty and noise, the bottom line is that economic fundamentals remain sound, even in a later-cycle environment. We believe that solid fundamentals will win out with equities eventually pushing past the high set on January 26, 2018. Our belief that global synchronized growth, still-accommodative central banks and a modest rise in inflationary pressures support our modest overweight to equities. But just like the new restaurant that failed to live up to the hype, it's important to have realistic expectations. While we expect investors who adhere to their long-term investment plan to be rewarded from exposure to equities, the ride will likely be bumpier and returns more muted than we saw in 2017.

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