The market is recovering because earnings are turning out to be not so bad

Barring a major decline on Friday, the S&P 500 will record its fourth consecutive weekly gain.

The markets are resetting. I have said this countless times: The stock market trades on estimates of a future stream of earnings, usually six months to a year out. At the end of December, the market was acting like the combination of additional rate hikes by the Fed, a slowing economy in China, tariffs and a potential slowdown in the U.S. economy was going to cause big problems for corporate earnings.

The market was trading like there would be no earnings growth — or even negative earnings growth — in 2019, and it was trading like a recession was imminent in late 2019.

What a difference a month makes. Earnings have reset lower but are still seen growing in the mid-single digits for 2019. The big question for the end of December — “Are we going to get a recession in 2019?” — is not being raised right now. Bulls insist the numbers are not there.

Understanding the earnings picture is complicated this year due to the effect of last year’s tax cuts. It’s important to try to separate the effect of the tax cuts on earnings from organic growth in earnings that would have happened without the tax cuts. Current consensus is that of the 23 percent earnings growth we saw in 2018, about 13 percentage points was due to the tax cuts, and 10 percentage points was due to organic growth, according to data from Strategas and Refinitiv.

The consensus for 2019 earnings growth is around 6 percent. That would be a decline from last year, but it’s not dramatic.

The market is having a difficult time figuring out what the right earnings multiple should be. Traditionally multiples contract when the outlook for corporate profits declines. The multiple is currently roughly 15 times 2019 earnings estimates, at the lower end of the recent historic range. It had been as high as 17 to 18 when the market was at its highs in 2018, definitely on the richer side. But it was about 14 when the market hit bottom at the end of December.

Right now, 15 feels about right.

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