As profit expectations drop, Goldman Sachs says stock market rally may hit the brakes – MarketWatch

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The U.S. stock market has hit a series of records of late, a rally spurred in part by the first-quarter earnings season, which was the strongest in nearly six years. But despite that, the earnings momentum that started the year has already shown signs of stalling, a factor that could limit Wall Street’s advance over the rest of the year.

Earnings expectations for the rest of 2017 have been coming down, eroded by an expected compression in profit margins and as investors push back the timeline for when the Donald Trump administration can possibly pass tax reform, an initiative that is deemed necessary for justifying current valuations. Goldman Sachs on Monday wrote that there was a “low probability” of such reform having any impact on profits this year.

“History strongly suggests that at some point this year investors will have to digest negative revisions to fourth-quarter earnings per share estimates,” the investment bank wrote in a note to clients. “If share prices do not fall alongside declining EPS forecasts, then portfolio managers will implicitly be accepting a rising P/E multiple, which is already stretched to near historical highs. Further valuation expansion seems unlikely, especially given our forecast of accelerating inflation and rising interest rates.”

Goldman has been warning about the deterioration in earnings expectations for months. In February, it wrote that Wall Street was “approaching the point of maximum optimism,” and that “financial market reconciliation lies ahead.”

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On Monday, it affirmed its year-end target of 2,300 for the S&P 500 SPX, +0.48% a level that would represent a decline of about 4.3% from current levels.

According to FactSet data, earnings for the components of the S&P-tracking SPDR S&P 500 ETF Trust SPY, +0.52%  are expected to be $13.17 a share in 2017, down 1.2% from the $13.33 that had been forecast at the end of October, the last period before Donald Trump’s unexpected electoral victory. The S&P 500 is up 13% since the end of October.

Compared with what had been forecast in October, expectations have fallen for the second, third, and fourth quarter, though the impact is less pronounced with time. Fourth-quarter expectations have just come down by a penny per share—to $3.55 from $3.54—while forecasts are down 3.7% for the second quarter, a drop from $3.28 a share to $3.16 a share.

The waning expectations come at a time when stock market valuations are widely seen as stretched, with prices at their highest since 2004 by one measure. At the same time, there have been some disappointing economic data, including first-quarter GDP, which was the slowest in three years.

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