Investors know that first quarter earnings reports are going to be weak, so investor attention will be on outlooks for the full year. While the fourth quarter’s sharp decline in stock prices turned out to be an overreaction to unfounded recession fears, the resilience of the subsequent recovery—and the prospects of further appreciation from here—may very well depend on whether management provides a sufficiently positive outlook to convince investors that we’re near the end of the current earnings slowdown. And even then, valuations have risen substantially since the December trough, making it more likely we’ll see the best opportunities in idiosyncratic stocks picks from here, rather than in entire sectors or style groups.
Expectations for first quarter and full-year 2019 earnings have already been reset lower making it more likely that companies will deliver ahead of those expectations. Thus far, only 15% of S&P 500 companies have reported and more than three quarters have beaten analyst forecasts. Not only is this slightly ahead of the historical average, stocks have responded more positively to those beats than is typical.
Some of last year’s fundamental headwinds are abating and we have already seen better-than-feared reports from companies leveraged to the housing sector and consumer staples. Both housing and beverage trends have improved. And the combination of the lifting of recession fears and signs of a resumption in technology infrastructure spending suggest to investors that the modest down cycle we saw in IT might be bottoming. We have yet to see any of the major IT players report, but we think it is likely select companies will deliver guidance ahead of expectations. But politics remains an important variable this earnings season as the China trade deal remains under discussion—although, it looks very likely to end well—and its resolution will have greater impact on some companies rather than others.
In health care, however, politics are playing a larger role. Last week saw the S&P 500’s Health Care sector trade down 4.6% on the emergence of concerns over political threats to health care insurers, pharmaceutical firms, and prescription benefit managers (PBMs). Clearly, the extreme proposals of the far left 2020 Democratic presidential candidates would, if enacted, create great upheaval for health insurers—indeed, if Medicare-for-All is adopted, private health insurers could disappear. Other parts of the healthcare business would also be likely to be severely disrupted. But for that to happen, Democrats would have to sweep the House, Senate, and the White House and be led by far-left progressives. Even then, moderate Democrats would have to be convinced to support such a drastic shift in the health care system. Indeed, one might view the extreme proposal as a negotiating tactic designed to shift the eventual outcome to a more comprehensive version of the ACA, with private health insurers still very much involved. But regardless of the probabilities of various political outcomes, investors pulled sharply back on the entire sector. This retreat occurred despite Health Care being one of only three S&P sectors expected to report positive earnings growth in 1Q19. Indeed, earnings growth for the group is likely to surpass 4% this year and 10% next.
Source: Factset, 4-21-19.
Moreover, many companies in that sector that would be unaffected by those political threats also traded down. For some reason, investors fled the entire sector—and ETFs may be to blame—causing a wider variety of companies to trade lower, not just the targets of the current debate. And therein lie the opportunities. The market saw significant declines in shares of medical supply companies, device makers, and analytical tool providers, yet few if any of these would be adversely affected by the current political threats. This sort of disruption has created bargains among companies in these three groups, given the drops in multiples, and we expect investors to latch onto these and push valuations higher as we go through 2019.