Did you hear “Yanny or Laurel?”

If you don’t know what I’m talking about, there’s a viral audio clip making the rounds which asks that question. Some people listen and hear Yanny. Others hear Laurel. It’s one of those things that’s open to interpretation.

One thing that isn’t hard to interpret is Q1 earnings season. S&P 500 firms crushed expectations. With about 93% of index constituents reporting, earnings are up 23.5% year-over-year.

Are tax savings responsible for the big gain? Sure, tax reform helped. But top line revenue also grew a healthy 8.1%. That is well above the 2011-17 average of 3.8% and exceeds early season analyst estimates for 5.1% growth.

Revenue trends reflect a healthy demand picture in the economy. U.S. GDP has accelerated 7 quarters in a row, and a spate of indicators are near cycle highs. Retail sales data reported last week showed 4.7% year-over-year growth. Meanwhile, within the manufacturing sector capacity utilization continues to firm, tightening to 78%.

With domestic growth and inflation outperforming foreign counterparts, the U.S. dollar has been on a tear, rising five consecutive weeks for the first time since 2015. This blog posited a favorable view on the dollar at the end of March. While I maintain that view over the intermediate horizon, I’m expecting consolidation short-term, as the dollar is starting to look overbought.

Contrary to popular belief, U.S. stocks can perform well alongside a rising dollar. Case in point: U.S. small-cap stocks are breaking out to new highs. The rally in the dollar is offering a tailwind to small-cap stocks linked to domestic demand. Over 70% of the S&P 600 small cap index sources revenue domestically.

Larger-cap names populating the S&P 500 index have yet to rebound to January highs. That’s a head-scratcher for many, considering how broad-based EPS acceleration is. Even if you strip out big cap darlings like Facebook, Apple, Amazon, Microsoft and Google, EPS is still up 23.4% in Q1.

Earnings and forward estimates are rising, but the S&P 500 index is only up 2% from the beginning of the year. That leaves the U.S. stock market suddenly looking reasonably priced. After peaking at more than 18x earnings, the S&P 500's forward P/E multiple has dipped to its five-year moving average for the first time since 2012. It’s now near its 16.3x long-term average, which it hasn’t traded close to since the 2016 U.S. presidential election.

2012 was an excellent time to go long U.S. stocks. So was November 2016.

What about now?

Like the Yanny versus Laurel debate, that question is more open to interpretation.

Potential earnings cliff

The stock market is always looking forward. That may be one reason why shares have been reticent to rise much, despite an excellent earnings season.

Investors are aware that current earnings establish a difficult base comparison for earnings next year. In other words, strong results now raise the bar for what companies must do going forward to maintain growth momentum.

The anticipated earnings cliff next year looks less threatening than a few weeks ago, thanks to better-than-expected Q1 results which have translated to improving forward views. Analysts now expect earnings to grow 8.8% in 2019.

Still, a slower growth rate can be interpreted as this market having already seen its best days. And forward estimates are just that—estimates.

Inflation

Most investment cycles end after inflation pressures crimp margins and kickstart a negative feedback loop. Corporations and investors gradually retrench and feed off one other until a cycle puts in a bottom.

For much of this cycle, policymakers have been pushing hard to stimulate inflation. In the U.S. at least, that mission appears finally accomplished. Inflation readings have yet to overshoot, but they are near the central bank’s target. Meanwhile, market-implied inflation expectations have broken above resistance to a multi-year high.

In prior years, P/Es levitated higher in tandem with inflation. That’s when deflation was the overriding concern. That relationship has morphed to become more consistent with the long-term norm, where higher inflation is met with lower multiples.

Costs are rising. The producer’s paid index last clocked in at 79—a level not seen since 2011. Financing costs are rising with interest rates. And given the mature stage of the employment cycle, some degree of wage inflation remains likely. All of this adds up to a strong likelihood we’re at peak profit margins in the U.S.

Bottom-line: Bulls can hang their hat on an excellent earnings season and strong breadth given the breakout in small-cap stocks. Bears can point to a strong likelihood earnings growth will slow from here, maybe quickly if input cost pressures continue to rise. So far this year, it’s a virtual draw.

My take is a similar tug of war will likely persist in the stock market through the end of the year, yielding a flat to down-a-little result. If I’m right, tactical trading and stock selection will be the keys to earning a satisfactory return.

Originally published by RealClearMarkets. Reprinted with permission. 

Disclosure: This material is not intended to be relied upon as a forecast, research or investment advice, and is not a recommendation, offer or solicitation to buy or sell any securities or to adopt any investment strategy. The opinions expressed are as of the date indicated and may change as subsequent conditions vary. The information and opinions contained in this post are derived from proprietary and nonproprietary sources deemed by Silverlight Asset Management LLC to be reliable, are not necessarily all-inclusive and are not guaranteed as to accuracy. As such, no warranty of accuracy or reliability is given and no responsibility arising in any other way for errors and omissions (including responsibility to any person by reason of negligence) is accepted by Silverlight Asset Management LLC, its officers, employees or agents. This post may contain “forward-looking” information that is not purely historical in nature. Such information may include, among other things, projections and forecasts. There is no guarantee that any of these views will come to pass. Reliance upon information in this post is at the sole discretion of the reader.