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What Will Be the Rally's Next Catalyst?

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Stocks continue to defy the skeptics, pushing the broad indexes into record territory. But persistent 'correction' chatter isn't going away either, keeping alive questions about the market's next move. I am adding to that debate in this piece by pointing out a source of support for the market.

Stocks need power to push higher, just as humans and machines do. This 'power' comes from a variety of sources, with interest rates and corporate profits as the big ones. Interest rates aren't a big worry for stock market investors at present, as the U.S. Fed has successfully convinced them that it will keep rates low for a long time even as it unwinds the extraordinary policy measures in a deliberate, thoughtful and transparent way.

Unlike interest rates, the earnings picture has been a lot less clear, with problems in the energy sector dragging the overall growth rate into negative territory last year. Positive growth returned in the last quarter of 2016 and accelerated into the first half of this year, with growth reaching double-digit levels in the first two quarters of 2017.

Many skeptics have been discounting this favorable turn in the earnings growth picture, citing the outsized contribution of easy comparisons at the energy sector for the elevated growth pace and referring to the never-ending cycle of downward revisions to forward earnings estimates. This skeptical narrative also refers to the decelerating earnings growth trend and the low-single digit earnings growth expectation for the current period as sufficient grounds to doubt the staying power of the market rally.

These are all reasonable points -- estimates continue to be trending down, the quarterly growth pace is decelerating and easy comparisons at the Energy sector are a factor in the aggregate growth level. But that doesn't mean that the earnings picture hasn't improved at all; it has improved in meaningful ways relative to the trend that was in place over the last two years.

Here are the three points in support of this view:

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First: the revisions trend isn't bad and actually represents a notable improvement over historical periods.

Earnings estimates for the September quarter have come down since the quarter got underway, with the current +3.2% earnings growth rate down from +6.3% on June 30th. This trend of negative revisions has been in place over the last many years. But what is different for Q3, as well as for the last three quarters, is that the magnitude of negative revisions to estimates is below the 5- and 10-year averages. The fact is that the tone and substance of management commentary and earnings preannouncements for the period is very favorable.

Second: the quarterly growth pace is no doubt expected to be only in the low single-digits in Q3, down from the double-digit pace of the first two quarters of the year. But the overall level of quarterly earnings is on track to reach all-time record levels in the current and coming quarters.

Our records show that the S&P 500 companies earned a combined $293.8 billion in the second quarter of 2017, a new all-time quarterly record, surpassing the previous record set in 2016 Q4. The total for the September quarter is currently expected to be $293.1 billion. But since more than two-thirds of the S&P 500 members exceed consensus earnings estimates in a typical earnings season, the final Q3 earnings tally will almost certainly be a new quarterly record.

This new Q3 record will not stand for much longer either, with each of the following quarters expected to bring in record tallies each.

Third: the growth pace is all around and not concentrated in the Energy sector alone. The Energy sector is undoubtedly benefiting from easy comparisons and that helps the overall growth picture, but it's incorrect to say that this sector is solely driving the growth pace.

The Q3 earnings growth pace drops by one half on an ex-Energy basis, but that wasn't the case in the last two quarters or the following two quarters. Looking at full year 2017 and 2018 expectations, earnings growth for the S&P 500 index is expected to be +7.4% and +11%, respectively. Stripping the Energy sector out of the S&P 500 index, the growth pace drops to +4.9% in 2017 and +10.4% in 2018.

In other words, the Energy sector's contribution is material, but it is by no means the only driver.

Putting It All Together

Earnings growth in the current and coming quarters may not be as high as what we saw in the first two quarters of the year, but it is nevertheless positive and steadily improving. The improvement is particularly notable on the guidance front, which has started showing up in reduced estimate cuts.

The fact that corporate earnings can continue to grow in a sustained fashion over the coming quarters is very impressive, particularly given where we are in the economic and earnings cycle. Greater appreciation for this fact should not only add to confidence in expectations for the coming periods, but also help support stock prices.

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Sheraz Mian

Sheraz Mian is Zacks' Director of Research. He determines which valuable data to use to assess winning stocks and funds. He is a contributor for Zacks Equity Research and Earnings Analysis, and his recommendations are often featured in Zacks Confidential.

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