Why stock-market bulls shouldn't sweat some bad earnings – MarketWatch

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Third-quarter earnings season kicked off this week, with investors hoping for signs that the record-highs in major indexes are justified by the level of activity in corporate America. The good news is there may be more wiggle room on this score than investors realize.

While trading in 2017 has largely been the story of changing market leadership—first bank stocks, then technology names—economic improvement is wider than is currently appreciated, which could help limit the pain in the event that a high-profile stock disappoints with its results.

“A small number of very large stocks, including the so-called FANG stocks, have contributed a large share of the overall cap-weighted return of the S&P 500 SPX, +0.10% in 2017,” Morgan Stanley wrote, referring to a quartet of large-capitalization technology and consumer discretionary stocks.

The group, which includes Facebook FB, +1.04% Amazon AMZN, +0.20% Netflix NFLX, +1.81% and Google parent Alphabet GOOGL, +0.56%  (Apple AAPL, +0.43%  is sometimes included as well), have contributed a hefty chuck of the overall market’s advance this year, due to both the outsize nature of their gains, as well as their heavy weights in indexes.

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These companies have historically posted blockbuster results, with soaring revenue, but while the stock market’s advance has been concentrated within the group, the same doesn’t apply to overall levels of top-line and bottom-line growth.

“In fact, contributions to earnings have become more diffuse across S&P 500 stocks since 2010 and concentrations of earnings and revenue growth rates have fallen since 2010—including analyst estimates for 2018,” Morgan Stanley wrote. While the market would no doubt take a hit if any of the major names were to disappoint, especially since many of them are seen as overvalued, “having lower concentrations for earnings and earnings growth reduces the risk that an idiosyncratic fundamental shock can have on the overall market fundamentals.”

It added, “the market is becoming less dependent on a small group of stocks to drive earnings and revenue growth numbers.”

The waning earnings concentration could been due to the yearslong bull market, as Morgan Stanley noted that it moves “up or down largely in opposition to the performance of the overall market.”

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There is a higher level of concentration on the sector level, although this is partially a reflection of their size within the overall economy. Large technology and bank stocks “dominate the list of stocks with the highest contribution to earnings and are well represented among the largest contributors to earnings growth,” the investment bank wrote. For 2017, Morgan Stanley estimated that Apple, Microsoft, J.P. Morgan, Wells Fargo & Co. WFC, -3.43% and Johnson & Johnson JNJ, +0.11%  would be the five stocks with the largest contribution to positive earnings.

This trend doesn’t hold up on the top line, however.

“The lists of top contributors to revenue and revenue growth are more diverse among sectors,” with consumer staples, energy, health care, and technology names all appearing, it wrote.

For the third quarter, Morgan Stanley sees earnings growth of 3.5% and revenue expanding at a 5.3% clip. Broadly, Wall Street expects companies to top consensus forecasts, which could allow the market’s rally to continue through at least the end of the year.

Read more: Third-quarter earnings seen as ‘an easy beat,’ could set up more stock market records

The third-quarter earnings season is just getting started, and most of the high-profile names to report thus far have been financials. On Thursday, both J.P. Morgan Chase & Co. JPM, +0.18%  and Citigroup Inc. C, -0.94%  reported earnings and revenue that topped consensus forecasts.