The S&P 500 earnings season is almost completed. Q1 operating earnings, which are 97.3% completed, were $27.90 on a bottom-up basis. That’s the third highest earnings in history. On an as reported basis, earnings were $27.60 which is the highest ever. Operating margins increased from 8.75% in Q1 2016 to 9.89%. It was a great quarter, but it needs to be looked at in context. The stock market has rallied since the Q3 2014 earnings record, so just getting back to even isn’t enough. The key is for the rest of the year to continue this momentum. While future earnings are always important to the market, the ‘pricing in’ of these great reports puts more pressure on them to deliver. The narrative that the energy decline was responsible for the earnings decline and they would rebound shortly ended up being accurate.

Three weeks ago, when I saw operating margins above 10%, near their record high, I felt this earnings growth momentum would be stalled because margins can’t expand to unlimited heights. However, with operating margins for Q1 falling as the results have come in, I think there’s slightly more room to run. There could be one or two more quarters with margin growth before the ceiling is hit. Alternatively, sales growth could drive profit growth, but without margins increasing, estimates will need to be cut.

On cue with this thesis, the last two months of earnings expectation changes for Q2 have been great. During the period before earnings season, expectations usually fall. The amount they fall gives us a clue as to how earnings will be because results rarely miss expectations. Often when results miss expectations, it’s because estimates weren’t cut enough, not because optimism was too high. That’s not to say reckless optimism doesn’t occur, but that’s limited to far our expectations. For example, analysts can pretty much get away with anything for estimates greater than 12 months in advance because there’s nothing to base these guesses on. The bias is always to the upside.

The chart below shows the changes in Q2 2017 earnings expectations. They fell as per usual, but they fell less than average. There has been a 1.7% decline in bottom-up estimates in the past two months. This is much better than the recent averages. In the past 4 quarters, the average decline is 2.5%. In the past 5 years, the average decline is 3.5% and in the past 10 years, the average decline was 4.2%. This is a good signal about how earnings will be. Unless there’s a big change in the next 4 weeks, there should be a second straight quarter of great results. The trailing-twelve-month expectations are for earnings to hit $105.52 which is 44 cents off the record high.

You can’t talk about earnings performance without mentioning the FANG stocks. The chart below shows their combined market value since October as a percent of the S&P 500. From the election to early December the Financials led the rally, but ever since then, it has been all tech. It’s not worrisome to see these firms growing so large. It is only worrisome when they start to disappoint on earnings. We’ll get another update next month. A slip up could derail the Nasdaq’s outperformance.

The chart below breaks down the expectations for earnings growth by sector throughout the world. You can see what I mean by analysts making optimistic guesses about the future. The 2017 estimates are all much different from the 2018 and 2019 estimates which are pure guesses. While it looks like the future estimates are lower than the near-term estimates, that’s looking at the numbers incorrectly. The 2018 earnings will have much tougher comparisons than the 2017 reports have had. The MSCI global index had a much rougher correction than the American stock market did in 2016 as it fell 18.9%. This is significant because 54% of the MSCI Index is made up of American stocks; it shows how the other markets underperformed. The other markets were impacted more by the economic weakness while the U.S. was the recipient of changes in the asset allocation of investors.

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Although earnings have been strong, because of economic weakness, the U.S. has actually started to lag the MSCI index lately. In the past 3 months, the index has increased 4.40%. Without America in the index, it’s up 6.08%. One of the metrics I have discussed in previous articles is the Citi Economic Surprise Index. It’s a popular way of quickly gauging how various economies are doing. It’s lagging in America, while it’s doing better in Europe. Before you decide to invest based on an index, it’s good to delve deep into its history to see if you can find any trends.

As you can see from the Bloomberg screenshot below, the American Citi Economic Surprise Index has done terribly in January, April, and June. July and August are the best months. This means we may see a decline in the index in the next 3 weeks and then see it rebound, soon afterward. The American stock market may start to outperform in the summer. One other point worth noting is that the American stocks have lagged earnings growth in the other areas in the chart above. I would ignore that factor because it depends on how you look at earnings. As I mentioned earlier, bottom up as reported earnings are at a record high. Earnings aren’t the reason the American market has underperformed.

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Conclusion

Q1 earnings were great and Q2 earnings look to be on a similar track. Great earnings and a rebound in the Citi Surprise Index can help American stocks catch up to the world index. On the other hand, the Fed is raising rates while the ECB is still pushing $60 billion per month in stimulus. This may be the reason behind the outperformance of Europe in the past 3 months. If that’s the case, the trend will continue because the ECB will continue its purchases until December, while the Fed is going to raise rates next week.