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As markets tread water, U.S. corporate earnings, estimates power ahead

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Wednesday, February 14, 2018 – Page B1

Market volatility has made a noisy comeback over the past couple of weeks, obscuring the fact that corporate profits are getting stronger and stronger.

Often considered the lifeblood of the stock market, earnings have, for the time being, lost their power to sustain market gains.

"The recent divergence between soaring earnings estimates and their plummeting stock price indexes has been remarkable," writes Ed Yardeni, a U.S. economist and strategist.

Whenever this global selloff ends - whether the bottom has already been hit or whether the correction is merely on pause - investors should find a solid profit backdrop on the other side.

U.S. earnings season is in its later stages, and it is shaping up to be a fruitful one. Of the more than 350 companies in the S&P 500 index that have released fourth-quarter financial results, 80 per cent of them have beaten Wall Street forecasts.

The increase in earnings per share for the entire S&P 500 is tracking at about 15 per cent over the same quarter last year, according to Thomson Reuters data. And while Canadian earnings season is still in its early days, analysts are expecting 19per-cent earnings growth year-overyear.

But perhaps more important than profits already earned are rising projections for profits to come - for U.S. equities at least.

U.S. earnings estimates for both this year and next have risen by about 7 per cent over the past two months, Ian de Verteuil, head of portfolio strategy at CIBC World Markets, said in a note to clients. "This is almost entirely due to the effect of U.S. tax reform."

Before U.S. President Donald Trump signed the Tax Cuts and Jobs Act into law in late December, the campaign to overhaul the tax regime looked like a long shot. As a result, few analysts had those tax savings fully built into company valuations.

By lowering the federal corporate tax rate to 21 per cent from 35 per cent, U.S. tax reform caused a quick mass revision upward of earnings estimates.

At the start of this year, U.S. profit growth in 2018 was forecast at about 12 per cent, while that figure sits at 19 per cent today, according to Thomson Reuters.

Profit goosed by tax reform provided much of the fuel for runaway gains U.S. stocks realized in January. While they were strong even before that, with the S&P 500 index having risen by just shy of 20 per cent in 2017, they found a new gear as 2018 got started. In the first four weeks of trading, the S&P 500 rose by 7.5 per cent, which represents an annualized gain of more than 150 per cent.

At that point, the market tipped into disarray, even as the signs of earnings strength kept piling up.

In just nine trading sessions, the S&P 500 declined by 10.2 per cent, registering the fastest correction on record outside of market crashes. Earnings forecasts have continued in the opposite direction, seeing material increases to estimates over each of the next four quarters in just the past couple of weeks.

"Earnings estimates continued to melt up," Mr. Yardeni said.

"That was because industry analysts have received very upbeat guidance on the earnings impacts of the Tax Cuts and Jobs Act from company managements."

There's no rule saying profit and stock prices can't disconnect, either on the way up or the way down. As the S&P 500 more than quadrupled from its postfinancial crisis low nearly nine years ago, up to its record high in late January, only about 40 per cent of those gains could be attributed to earnings, according to David Rosenberg, chief economist at Gluskin Sheff + Associates Inc.

"It is not always just about the fundamentals," Mr. Rosenberg said in a note. "There are technicals, valuations, sentiment, fund flows, and market positioning to consider at any moment in time."

The flip-side of the same rule can be seen in the underperformance of Canadian equities.

The S&P/TSX composite index is roughly flat since the summer of 2014, while corporate earnings have grown by nearly 30 per cent over that time, Mr. Rosenberg said.

The early results from fourthquarter earnings season in Canada are favourable, with nearly two-thirds of companies outperforming forecasts. And there will be plenty of earnings fodder for investors through the rest of this week with several big Canadian companies due to report, including Brookfield Asset Management Inc., Sun Life Financial Inc.

and a number of energy names - Enbridge Inc., TransCanada Corp., Encana Corp. and Cenovus Energy Inc.

But there are a couple of things standing in the way of Canadian equity performance catching up with earnings, Mr. de Verteuil said. First, the domestic energy sector has a long-term pipeline capacity issue keeping Canadian oil deeply discounted against U.S. crude.

And secondly, lower corporate U.S. tax rates will make Canada less competitive against U.S. peers, Mr. de Verteuil said. "The combined effect of U.S. tax reform and a more protectionist bent in Washington suggests the next 12 months will be much more challenging for Canadian businesses."

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