Over the last few months, investors have suffered through a 16% drop in the S&P 500, from September to the bottom in late December, and have been relieved to see the recovery of 15% from that bottom by last Friday. The market remains 7.6% below its September peak, so many wonder whether the recovery continues or sputters out here. In this sort of environment, narrowing one’s focus to stocks exposed to more specific drivers is likely to be the better play.
The fourth quarter fears of an imminent U.S. recession have abated and that allowed the market to bounce back these last weeks, but those fears could resurface at any time. Recent economic data are not yet signaling recession and the Federal Reserve’s more “patient” stance has alleviated investor concerns that the Fed, in its determination to keep inflation under control, could inadvertently trigger the next recession by being too quick to raise rates further. This does not mean that the risk of a recession is off our radar screen, but job creation remains strong and unemployment low. More importantly, corporate revenue and profit growth, while weakening this quarter, looks poised for a solid rebound in the second half.
We’re about halfway through earnings season and most companies have delivered results ahead of expectations. Earnings growth for 4Q18 is coming in over 12% higher than a year ago, marking the fifth straight quarter of double-digit earnings growth, and is putting the S&P 500 on track for 20% earnings growth for all of 2018. While that points to a healthy background for corporate valuations, the real story lies in outlooks for this quarter and the full year. 72% of companies, which have reported earnings thus far, have reduced 1Q guidance relative to expectations, and that helps explain the market’s lower level relative to the high reached in September. Going forward, we expect cautious guidance to continue and political noise to create further volatility. Investors need to be prepared for this volatility while at the same time keeping an eye on the more distant potential for corporate profit growth. Remember that owning stocks gives investors claims to the entire future potential for profit generation, not just those of the next quarter or two. And company guidance thus far indicates that weakness early in the year is likely to give way to better results in the latter half of 2019.
The economic backdrop for corporate profits, however, is deteriorating in the rest of the world even as the U.S. continues to add jobs and to generate GDP growth estimated to be around 2.4% this year. Multinationals are likely to be hardest hit by slowing growth in Europe, but outlooks depend critically on non-cyclical, industry-specific drivers. Moreover, the trade issues that are compromising European growth have less of an impact on the U.S., since our economy relies much less heavily on exports as an engine of growth. This leaves secular drivers more firmly in control. Health care companies, for example, are expected to see 7% earnings growth in 1Q, despite this global slowdown. Moreover, even though concerns have risen regarding the potential for new drug pricing regulations, stocks are moving higher since pharmaceutical companies are coming through with more novel treatments for the most vexing illnesses, and those new products point to years of earnings growth. Info Tech is supposed to see an 8.9% decline in earnings this quarter, but deliver 3.5% growth for the year. That points to a much stronger second half, reflecting a short-term reset in production and inventories. Much of that growth is being driven by the continued expansion of the internet, the upcoming move to 5G cellular technology, and the rise in “smart” systems across all sectors of the economy. And while financials fared poorly last year (after an exceptional 2017), even modest economic growth implies rising income from lending, trading, and banking activities and has helped to propel many bank stocks ahead of the broader market already this year. So while recession worries may resurface and the China trade war may take longer to sort out, the forces driving new product development and sales should prompt investors to take a longer-term outlook and to recognize that company- and industry-specific stock selection has become more important than ever.