Earnings season delivers the goods, but risks lie ahead

About 90% of the S&P 500 has now reported earnings for the third quarter (Q3), and like an election night where most constituencies have finished their counts, the market has delivered its verdict. Earnings rose 26.7% over the period, while sales were up 8.3%. Sales did not grow as strongly as in Q2, but earnings were up for the fifth quarter in a row.

The strongest growth was seen in oil and gas, where earnings were up 124%, and sales were almost a fifth higher. This came off the back of oil touching a three-year high at the beginning of October – following this the commodity moved to a 52-week low, so earnings from the sector in the next quarter may not be quite so strong.

One interesting element from this earnings season has been the negative reaction in stock prices. Data compiled by Deutsche Bank showed that the S&P 500 has been negative for only the third time in the past five years, while FactSet notes that the average price change over the four sessions around an earnings report has been -1.5% for this quarter, compared to an average of +1% over the previous five years.

Investors are clearly beginning to fret that valuations have gone too far, too fast, particularly in the tech sector. Expectations for 10% earnings growth next year are now potentially too rosy, while the gains in margins are unlikely to be repeated in the near term.

In addition, equities face a rising US dollar and falling oil prices, both of which may bear down on earnings in the coming year. In 2014 and 2015 a falling oil price hurt earnings overall, although the effect was most pronounced in the energy sector. Operating margins have risen from 8% at the beginning of 2016 to 13%, a pace of appreciation that is unsustainable in the near term. If margins fall, then earnings will shrink too, putting further pressure on equity markets.