Will Falling Corporate Earnings Cause a Market Correction?

The present earnings season was probably one of the worst since the great recessions. Banks tumbled, brick and mortar retailers were hammered, and even Apple (AAPL) shared a terrible quarter reporting its first year-over-year sales decline.

I had warned investors about the overvaluation of the market several times in the past. The falling corporate profits are further eroding the fundamentals, making the stocks more expensive. For the companies that have reported earnings, earnings have dropped 6.3% on a year-over-year basis, marking the sixth successive quarter of earnings declines — the longest period of successive drops outside of a recession.

The analysts had set the bar pretty low for the companies, which is why it isn’t surprising that most of the companies managed to surpass the estimates yet again.
However, the chances of the market sustaining such a high valuation despite growth concerns and falling earnings are pretty low.

However, banks like Goldman Sachs expect the primary concerns—the strength of the U.S. Dollar and slump in crude prices—are expected to ease in the coming quarters. Goldman Sachs expects a recovery in corporate profits. According to FactSet, corporate profits should rise by 7.5% by the end of the year.

Despite the bullishness, I am still skeptical about the estimates due to several reasons. The first is that I don’t trust Goldman Sachs. Secondly, rising wages will likely put downward pressure on corporate earnings. As per Motherjones.com “U.S. businesses are facing a problem that many haven’t thought about in years—rising wages. That could be one factor that tips over a market that has the uncomfortable combination of declining earnings and high valuations.

Workers, for the first time since the financial crisis, are demanding raises and actually getting them—or they are walking. The number of workers quitting jobs has increased, a sign they are confident they can get new jobs, and companies are loathe to lose good workers. It now takes 27 days to fill a job, the highest since at least 2001.”

Moreover, the potential of another rate hike by the Fed amid slowing economic growth can further put downward pressure on the market. While the falling profits may not necessarily cause a market correction, it will be difficult for stocks to sustain its current valuation. As a result, I am currently bearish on the stock market and would recommend investors to hedge their long positions by having at least 40% of their portfolio short by companies that can fall even in the most bullish on market.
Published on May 20, 2016
By Ayush Singh

Copyrighted 2020. Content published with author's permission.

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