When the market reacts positively to bad news, pay attention

The time to sit up and take notice is when the market does the opposite of what you expect. If the oil price rises, inflation expectations surge and shares duly retreat, that tells you little. If, on the other hand, peace talks stall, the US plays Iran at its own game by blocking the Strait of Hormuz, the oil price pushes above $100 again, and the S&P 500 still ends the day 1% higher - as it did on Monday - something more interesting is going on.

Two things actually. First, it confirms investors’ belief that both the US and Iran have now had enough of this conflict. Whatever their leaders might say for public consumption at home and abroad, they are both looking for a face-saving exit. Second, it says that the market really does want to get back on the front foot.

It took a month for the S&P 500 to lose a tenth of its value and just two weeks to claw it back again. That is a reversal of the usual asymmetry - shares normally fall faster than they recover.

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The conventional wisdom about this conflict is that the longer it goes on, and the longer the oil price stays high, the worse the outlook becomes for shares. There is some logic in that. Oil in storage and already in transit at the outbreak of hostilities has disguised the economic impact of the supply shock. Once the last tanker is unloaded, and the storage tanks are drained, the shortages will become less theoretical.

But since last week’s ceasefire, investors have focused on another time lag. Every day that passes now without further Iranian retaliation is a sign that both sides are working towards a grudging but mutually acceptable pause. The longer this goes on, the better.

It is no accident that the change in market sentiment has coincided with the start of the first quarter earnings season. In the dog days either side of Easter there was not a lot to focus on except the news flow from the Gulf. Now investors can switch their attention to what they are better at reading anyway, the outlook for company earnings.

If they had wanted to sell, they had their opportunity. They didn’t take it. Now they have refocused on the fundamentals of earnings growth and valuations. And broadly speaking they like what they see.

The current growth forecast for America’s biggest companies in the first three months of the year is just under 13%. If achieved, that will be the sixth consecutive quarter of double-digit year-on-year gains. Were it not for the oil shock, we would be celebrating a continuing surge in profits. We would be noting how rising earnings are bringing valuation multiples back to more reasonable levels.

Even that double-digit growth trajectory might understate the strength of corporate America. Data provider FactSet said last week that earnings growth could approach 20% in the first quarter if actual profits exceed forecast earnings to the extent that they have over the past decade.

In 37 of the past 40 quarters, earnings have beaten expectations - only during one quarter in the pandemic and two while interest rates were rising in 2022 has this not been the case.

Over that 10-year period, three quarters of companies have beaten expectations by an average of just over 7%. From the end of the period under review until the close of the subsequent reporting season, the earnings growth rate has risen by 5.8 percentage points.

So, earnings are one reason for the market’s pent-up desire to head higher. The second is valuation. Higher profits in recent weeks have disguised a significant reduction in the multiple of earnings that investors are prepared to pay. The market has got cheaper, even as it has gone sideways.

The average multiple of earnings for an S&P 500 stock had fallen by a fifth from its peak last October to the end of March. Had it not been for the offsetting boost from higher earnings, the US benchmark would have dropped into bear market territory. Strip out the fast-growing tech stocks and much of the rest of the market already has. More than half the companies in the Russell 3000 index have fallen by at least 20%.

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Now, it is possible that this de-rating is justified by the earnings and inflation squeeze that many see around the corner. Fifty years ago, after the Yom Kippur war and the consequent Arab oil embargo, shares fell by 40% as stagflation ate into company profits. Perhaps the market is simply doing its job, pricing that downturn before it is evident in the data. Or maybe it has just overshot.

Bank of America published its monthly fund manager survey this week. It reported the most bearish sentiment among professional money managers since last June, shortly after the Liberation Day tariffs. Gloomy sentiment, high cash levels and cautious positioning was a contrarian buy signal then. The sharp reversal of the March correction suggests it may have been again.

The Pavlovian response of buying the dip has paid off. For any rally to be sustainable, however, those buoyant earnings forecasts must be delivered in full, and preferably beaten. The market’s positive reaction to bad news told us something useful this week. It will be just as interesting if the market now surprises in the opposite direction, shrugging off apparently good news in the reporting season ahead. We need to watch not just what the companies tell us, but how the market responds.

This article was originally published in The Telegraph.

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