The latest corporate results season in Europe, while solid, was marked by lukewarm share price moves even for companies that reported better-than-expected profits - a sign that strong earnings growth is no longer a reason for investors to keep chasing richly valued stocks.
The euro's runaway strength - it is up 13 percent against the dollar this year - is a blow to exporters and has led to some skepticism that European companies will be able to keep delivering double-digit growth and analyst sentiment is starting to sour.
This has left European stocks, market darlings at the start of 2017, down more than 6 percent from their May peaks despite a particularly healthy turnaround in corporate profits in the first half of the year.
"People's expectations were already elevated, and the (earnings) data didn't lead people to raise their numbers any further," said Graham Secker, European equities strategist at Morgan Stanley.
"Europe looked tactically really quite overbought after the French election so you've already priced in quite a lot."
A stellar round of first-quarter earnings in Europe, during which companies posted the best growth in seven years, and fading political risks spurred a rush back into regional stocks, putting them on the path to record highs.
However, as valuations rose well above long-term averages and more money was pumped into Europe, the bar for earnings surprises rose. On the flipside, tolerance for earnings disappointments continued to fall.
Analysts at JPMorgan and Bank of America Merrill Lynch (BAML) have pointed out that investors have punished shares of companies missing estimates much more than they have rewarded those that outpaced forecasts.
More than half the companies in the MSCI Europe index beat earnings expectations in the second quarter. Yet, on average, shares of these companies were flat over the two days after reporting, according to Thomson Reuters data.
Meanwhile, for the companies that missed estimates, shares fell 0.6 percent with healthcare, materials and the tech sector seeing drops of between 2 and 4 percent, the data showed.
This echoed a similar trend in the United States, where 73 percent of the S&P500 beat estimates and, like Europe, shares showed little reaction.
BAML said in a note to clients that for the first time since 2000, shares of U.S. companies beating earnings were not outperforming, suggesting investors globally are looking beyond just profits.
"Expectations have caught up with what have been solid fundamentals and we are at a juncture now where some macro indicators have shown signs of topping out," said Ronan Carr, European equity strategist at BAML.
The strengthening euro, surging above $1.20 for the first time in 2-1/2 years this week, has also piled pressure on earnings estimates for big European companies, many of which derive most of their revenues overseas.
"The sell-off over the last couple of months has been accompanied by underperformance of exporters relative to domestically focused stocks, which suggests currency has been a factor," said Dennis Jose, European equity strategist at Barclays.
BENEATH THE SURFACE
Investors now appear to be digging into details of how companies are generating these earnings and scouring statements for everything from profitability to signs of market share gains.
"Companies increasingly know the importance of meeting Street targets, because they know that the share price will be hit otherwise," said Juliet Cohn of Principal Global Investors.
"It's important to look beneath the surface to see how they are achieving their numbers. Are they benefiting from a reduction in tax? Are there one-offs? Is the order book very lumpy?"
One area garnering attention is profit margins, where year-on-year growth has been significantly weaker this quarter in Europe after double-digit growth in the two previous quarters, JPMorgan data showed.
Relatively weak performance last year for some sectors could also be artificially inflating earnings growth, investors said.
"We may have seen the best year-on-year change in earnings growth we can expect,” said Jeff Donlon, managing director of global strategies at Manning & Napier.
“The comparatives get a bit more difficult for a lot of different industries going forward, particularly the oil industry which is still cycling through some very low oil prices from early 2016,” he added.
The energy sector's earnings rebound delivered nearly half the earnings growth in Europe in the second quarter, Blackrock analysts said.
But even in this sector, investors have shrugged off the headline earnings figures, eyeing instead the danger to dividend payments arising from a potential hit to profits as oil prices stay stubbornly low.
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