The US stock market exploded out of the financial crisis, with the S&P 500 surging 220% from its March 2009 low of 666 to its May 2015 all-time of 2,134.
This occurred despite lacklustre growth from the US economy.
How could that be?
In a sentence: the US stock market is not the US economy.
Unfortunately, that story has gone from good to bad at a time when the Federal Reserve has plans that could make things much worse for investors.
The stock market consists of the biggest businesses that have massive scale and are able to obtain cheap financing by directly tapping the global capital markets.
Notably, S&P 500 companies generate nearly half of their sales overseas. Many of these companies have been able to outperform the US by taking advantage of the massive growth opportunities in emerging markets like China.
But overseas exposure has now gone from advantage to disadvantage as overseas growth sputters while domestic growth remains healthy.
Factset's John Butters recently compared the expected revenue and earnings for S&P 500 companies with over 50% of sales generated in the US against companies with over 50% of sales generated abroad. What he observed were two dramatically different stories.
The estimated earnings decline for the S&P 500 for Q3 2015 is -4.4%. For companies that generate more than 50% of sales inside the U.S., the estimated earnings growth rate is 3.1%. For companies that generate less than 50% of sales inside the U.S., the estimated earnings decline is -14.1%.
The estimated sales decline for the S&P 500 for Q3 2015 is -2.9%. For companies that generate more than 50% of sales inside the U.S., the estimated sales growth rate is 1.4%. For companies that generate less than 50% of sales inside the U.S., the estimated sales decline is -12.1%.
These two paragraphs are illustrated in this jarring chart.
The most important driver of stock prices is earnings and expectations for earnings growth.
And during a time when valuations (e.g. the price/earnings ratio, or PE) are stretched, earnings growth is what keeps stock prices going.
'The key to the outlook for global equities is earnings, with global valuations in line with historical averages, a supportive monetary policy backdrop, and very bearish sentiment, a major hit to (earnings per share) is the main risk for the market,' Barclays' Ian Scott wrote in a note to clients.
'It's amazing how forgiving the general commentary has been on profits and even the broad economy,' Deutsche Bank's David Bianco said in an email to Business Insider.
'Many seem to celebrate the absence of a recession. The labour market continues to tighten ... but other than some bright spots like auto and housing, growth is extremely weak with underlying drivers like productivity and investment disturbingly poor and S&P profits are not growing.'
Not only are earnings in the US not growing, but by many estimates, earnings are actually contracting. Societe Generale's Andrew Lapthorne has been sounding the alarm on earnings for a while, and he reiterated this call in a note to clients on Monday.
'The chart below shows the annual change in 12-month forward S&P 500 EPS expectations,' Lapthorne said. 'This series is based on forward consensus expectations and therefore excludes many of the write-downs and exceptional items that are currently pushing down actual reported profits.
'It is more akin to operational profits and has never been this negative outside of a recession!'
All of the concerns above are particularly concerning as the Federal Reserve appears to be on the brink of hiking interest rates, which could put further pressure on profits.
'Higher rates are always an incremental negative for the stock market,' veteran market strategist Richard Bernstein wrote. 'The probability of a bear market increases when the Fed increases rates faster than the improvement in earnings growth.'
The Fed now risks being wrong footed, and the problem for the stock market today is the Fed is 'threatening' to raise interest rates at a time when S&P 500 earnings growth is actually negative ... We've been concerned for many months that the recipe for the much- anticipated correction could be the Fed hiking rates when earnings growth was negative.
Bernstein attributes the recent market volatility to investors and traders discounting this, saying it's 'easily explained by the unusual combination of tightening monetary policy and negative earnings growth.'
HSBC illustrated this another way by showing the average trajectories of S&P 500 prices, earnings, and PEs around the time of rate hikes.
'The lesson from the past seven tightening cycles is that equities may wobble when the Fed raises rates, but quickly recoup losses,' HSBC's Ben Laidler wrote. 'The key to this positive historical performance is earnings growth. Valuation multiples typically contract as the Fed tightens.'
Without earnings growth, contracting valuations -- as measured by the price-to-earnings (PE) ratio -- mean stock prices will have to fall.
The analysts at FactSet observed that with stock prices falling, the changes in S&P 500 earnings estimates and prices are moving in the same direction for the first time since Q4 2012.
For investors long the stock market, the question is how long will this negative trend in earnings last.
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