A woman's umbrella turns inside out as she walks past the Nasdaq MarketSite during a snow storm in Times Square, Midtown New York March 20.Adrees Latif/Reuters
Ever since the Great Recession, American equities have had to climb a wall of worry – facing debt ceiling debates, the so-called fiscal cliff, a possible break-up of the European Union, and the end of quantitative easing from the Federal Reserve.
Despite all these potential headwinds, the S&P 500 has managed to march steadily higher with few blips along the way, rising to new all-time highs.
Sam Stovall, U.S. equity strategist at S&P Capital IQ, highlights the next daunting challenge on the horizon for the benchmark American index: The top-down fundamentals are not painting a pretty picture.
"Now that the obsession with the Fed has likely subsided for a bit, the U.S. equity markets may have a new worry to contend with: Earnings growth," he writes. "S&P Capital IQ consensus earnings per share estimates for the S&P 500 continue to slide for 2015, now registering only 0.3-per-cent growth as compared with a high single-digit growth forecast just a few short months ago."
If share price appreciation exceeds realized or expected earnings growth, this necessarily entails that stocks are becoming more richly valued on a trailing or forward price-to-earnings ratio.
Since Jan. 15, when the S&P 500 closed at its lowest level of the year, the 12-month trailing price-to-earnings ratio has expanded from 17.8 to 18.9 times, while the forward price-to-earnings ratio has risen from 16.4 to 17.9 times.
The anticipated earnings for the S&P 500 are dangerously close to indicating a looming "profit recession" – which would also, on the surface, send a dire signal about the health of the U.S. economy.
"[L]ike the recognizable pair of Astaire and Rodgers, downward earnings per share growth trends and economic recessions also go hand-in-hand," says Mr. Stovall.
In the post-war era, all ten U.S. recessions have been preceded by, or occurred in conjunction with, downward-trending or negative earnings per share growth, though there have been three false positives in 1967, 1985, and 1998.
The reason for the sharp downward revisions to the index's earnings growth is, as one would expect, due to the collapse in crude prices. Profits in the energy sectors are expected to fall 56 per cent year-over-year, according to Mr. Stovall.
"With the first quarter 2015 earnings per share reporting season soon to be upon us, investors will need to decide if the precipitous decline in 2015 earnings per share growth estimate foretells the approach of an overall recession, or merely a slowing of the profit sprint, as a result of running out of Energy," the strategist writes.
The effect of Federal Reserve policy on a possible "profit recession" is paramount.
The central bank's dovish commentary last week sparked a sell-off of the U.S. dollar and decline in bond yields. If sustained, these developments would improve the profit outlook stateside.
Compared to 1998, the last period of sub-1-per-cent earnings growth that was not accompanied by a recession, corporations are able to borrow money at much lower interest rates. Debt-fuelled buybacks have helped fuel earnings growth throughout this bull market, and that story has not been derailed.
A lower greenback also provides support for commodity prices, and would mitigate the anticipated plunge in profits for energy producers.
In addition, a softening U.S. dollar would help large multinational firms that generate a large portion of their earnings abroad.
On the other hand, the rising greenback, which reflects investors' preference for U.S. dollar denominated assets, was cited as a key contributor to the S&P 500's multiple expansion.
So for equities, currency fluctuations are clearly a mixed bag. The interplay between the U.S. dollar's effect on valuations and profits is something to keep a close eye on during the upcoming earnings season and the months ahead.
But it's safe to say that profit growth slowing to a crawl would not bode well for the S&P 500.