This is the key to the stock market’s future

Photo: Win McNamee/Getty Images.

It’s not too hard to feel good about stocks right now.

After a precipitous decline in January and the first half of February, stocks have staged a historic comeback and are now in positive territory for the year. The economy has showed continued signs of strength, and the Federal Reserve is on hold.

What could go wrong?

According to Erik Ristuben, Chief Investment Strategist at Russell Investments, the future path of the stock market is contingent on one thing.

“I want to be clear earnings are absolutely the key for 2016,” Ristuben told Business Insider. “Earnings are the only one of the three cycles that can show any significant improvement, and if that happens it will be very good for markets.”

Ristuben’s three cycles are: the economic cycle, the interest rate cycle, and the earnings cycle. The first two, he said, are reaching their latter stages as the Fed begins the process of hiking and GDP growth continues its slow, steady pace. Earnings is the only one of the three that has a possible tailwind.

Currently, earnings are doing terribly. Corporate earnings for the S&P 500 have been declining for the past three quarters, and according to John Butters of FactSet, the upcoming reporting season isn’t going to be any different.

“For Q1 2016, the estimated earnings decline is -8.5%,” wrote Butters in a note to clients Friday. “If the index reports a decline in earnings for Q1, it will mark the first time the index has seen four consecutive quarters of year-over-year declines in earnings since Q4 2008 through Q3 2009.”

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Now the logical response to that news, and Ristuben’s assessment of earnings’ importance, would be to assume that stock prices are set up for a collapse. No so fast.

“The reality of the situation is that earnings faced three major headwinds over the past few quarters, and we expect that to change,” said Ristuben. Ristuben’s three issues were:

  1. The dollar: “The strength of the dollar, particularly for multinational companies, has been crushing earnings. However, dollar strength happened a while ago, so there should be a lessening of that headwind.”
  2. Commodity prices: “Energy companies were hit with a 60% or so drawdown on earnings, there simply isn’t that much downside left.”
  3. Inventory backlog: “The backlog of product slowed down sales and earnings. And if you don’t expect a recession, eventually customers are going to begin to place new orders and you’ll have to turn to machines back on.”

David Kelly, chief global strategist at JP Morgan Asset Management, agreed with this assessment.

“I admit it looks bad for profits, but it’s a narrow issue that’s focused mostly on 2 things: the dollar and oil,” said Kelly. “There’s just a lot of fog out there, and until those issues clear up we won’t get a clear picture.”

Both Kelly and Ristuben believe that earnings will increase over the year as these short-term problems fade. But, long-term cyclical issues such as employee wages, can also cut into profits, which has lead some analysts to fear that by the time the dollar and oil problems go away, it will be too late for earnings to rebound.

To Ristuben, the hope there come from inflation.

“The variable on the long-run factors is pricing power,” Ristuben told us. “If wage pressures go up and CPI and PPI don’t go up there will be serious pressure on earnings.”

Inflation has been stubbornly low but if companies can raise their prices, a wage increase could be offset for a while.

Ristuben expects earnings to come back, increasing by 3% to 5%. This level of increase is enough to support stocks some, but not drive them significantly higher.

With the sheer number of moving parts — inflation, wages, commodity prices, and the dollar — there is significant uncertainty, however, and investors should keep their eye squarely on earnings.

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