Earnings season got off with a bang last week, though you wouldn’t know it by watching the market on Friday. Three major banks reported results well ahead of expectations, but all subsequently traded lower for the day. Is this a sign of things to come as earnings season kicks into high gear this week? Friday’s cautious trading was partly positioning in advance of a weekend many expected to include breaking political news of unknown impact, but it also hinted at the dangers of the particularly high expectations money managers hold for first quarter results. While political events may continue to prove disruptive, high expectations for earnings bear closer scrutiny since these point to the potential for stocks over the long term. We see strong underpinnings for growth, but that doesn’t mean we won’t see some short-term volatility. It just means that investors may need to hang onto their hats as we traverse the bumps.
Earnings growth expectations for the first quarter aren’t just high, they’re very high at 17.3% over Q1 2017. Analysts expect earnings to top growth levels not seen since the first quarter of 2011 – that is, right at the beginning of the recovery. Moreover, analysts expect growth to remain strong for the rest of this year and next. Despite this outlook, the S&P 500 has pulled back to early December 2017 levels and now trades at 16.4 times 12-month forward earnings, down from its peak at 18.5. This is very close to the S&P 500’s 25-year average multiple, and with 2019 growth looking to top 10%, it suggests the broader market may be cheap.
The concern, of course, is that earnings growth this year is benefiting from the one-time boost to the level of profits from the corporate tax cut, and so earnings growth will slow significantly in coming years. But not all companies have worked out the full benefit, and analysts have therefore built into 2019 forecasts an additional uptick in earnings. Beyond the published estimates of first quarter results, however, are the “whisper” numbers—forecasts of company results made by money managers—which are likely to be notably higher. The analysts behind the published numbers only have the incentive to be on the right side of the average—or “consensus”—estimate. Those with a “Buy” rating will publish estimates slightly above the consensus. (Imagine they are playing “The Price is Right” so never want to go over the actual EPS a company delivers.) Money managers know this and generally expect companies to report better estimates than those published by the analysts. Companies may beat first quarter estimates and still wind up trading down. Don’t be alarmed. If companies hit their expected growth numbers, they will be well positioned for the future. The future matters more than the past, and the multiyear future—2019, 2020, and beyond—matters even more for the long-term investor.
Earnings growth must eventually slow, but if the market fails to appreciate materially (7-10%) this year, stocks will trade below their long-term average. That seems unlikely given the multitude of fundamental tailwinds we see persisting over the next couple of years (at least).
Real GDP growth will likely be close to 3% this year, wages are rising, and unemployment will likely continue lower. This presents a solid backdrop for continued firm profit growth. More importantly, we see several trends that will allow specific industries and companies to grow well in excess of nominal GDP growth. S&P 500 companies have, on average, seen revenues and profits grow far faster than nominal GDP over the last several years. Some view this as unsustainable and suggest it is evidence that the market must see a further pullback. But any amount of leverage insures this can happen on a sustainable basis. They also forget that the companies in the S&P 500 are a small subset of the overall U.S. economy and that those firms have much greater exposure to international markets, such as China, where growth is often more rapid. For these reasons, S&P 500 companies can conceivably see both revenues and earnings grow faster than GDP for extended periods. These companies are also the ones which have succeeded over time. This “survivorship bias” in listed companies is another factor which tilts growth of the market higher than growth of the economy as a whole.
And just as the S&P 500 is a subset of the U.S. economy, investments can further target a subset of the S&P 500 to gain leverage to those companies exposed to the strongest earnings trends. We continue to see particularly strong tailwinds for certain banks (rising interest rates), consumer products and services companies (demographic trends), industrials (geopolitics), technology firms (data, data, data), energy companies (more fracking), and in many other areas. We may see some volatility from political dynamics and from high earnings expectations, but companies in multiple segments are buttressed by solid economic fundamentals and many have company- and industry-specific drivers for multiyear profit growth.