Earnings season begins this week with six of the largest banks reporting, and while investors have been encouraged by somewhat positive economic data and progress (maybe) on China trade talks, the real test will come in the form of earnings guidance. We should expect companies to be cautious—and we have seen hints of that in a handful of pre-announcements—but that doesn’t necessarily spell doom for the resurgence in equity prices. A little caution is likely to be welcomed by investors who themselves see natural softening in some key drivers of the generalized economic expansion. If companies acknowledge that, but still point to reasons why their particular industry or segment still has tailwinds, investors are likely to respond positively. That may be a high bar, though, so look for volatility to remain the key theme through earnings season.
Lennar (LEN), a home builder which reported last week, is a case in point. In an unusual move, LEN announced that it would not be providing guidance for 2019, citing elevated sources of uncertainty. That would normally cause a company’s stock price to plummet, but LEN rose roughly 8% that day. While the company warned of its difficulty seeing the future, it also noted that several housing-specific trends made it likely that sales would eventually strengthen—low unemployment and rising wages mean more folks are looking for homes and moderating mortgage rates are sending home buyers out in search of property. Just that little bit of reassurance allowed LEN to surge. And that tells us something about how tentative is the market’s sense of foreboding. While there have been plenty of pundits calling for a 2019 recession, it turns out that when confronted with solid economic data, those fears just crumble.
This also suggests, however, that investor expectations can be jolted about pretty easily, so earnings season is likely to create some erratic moves in stock prices. In areas where the negative sentiment has already caused a sharp pullback, we see less to fear from the upcoming earnings calls. Take, for example, the Apple iPhone supply chain – when Apple cut its guidance for iPhone production for the first quarter, the news was already mostly baked into stock prices of several suppliers and those valuations moved relatively little on the news. Apple, itself, however, was crushed even though so many suppliers had previously lowered guidance and warned of lower iPhone builds. Many companies involved in supplying chips to consumer electronics, cars, and communications equipment are trading at multiples of 10 times this year’s earnings or less, and such multiples suggest the market sees no growth ahead. Given the rise in electronic content in so many areas of our everyday lives, the evaporation of growth in such companies seems unlikely. Fear once again has taken over from forecasts well grounded in fundamentals.
Technology is not the only sector where valuations have moved into no-growth territory. During the fourth quarter we saw a marked disconnect appear between fundamental company value and stock price behavior in most sectors. Consumer Discretionary stocks were hit particularly hard as stock prices pulled back despite the improvements we are seeing in household income and spending trends from rising employment and wages. Financials are also building in a large risk premium despite the strong results many have reported through much of 2018. While interest rate forecasts have come down, overall bank activity continues to strengthen, and the tight labor market, as indicated by strong job openings, implies that interest rates will be pressured higher on further wage increases and higher inflation.
The solution to excessive fear is better information, and earnings season can help resolve concerns over the pace of business last quarter—unlikely to be as bad as feared—and point to areas of strength (and weakness) for this quarter and this year. While investors are rightly concerned about the trade war’s resolution, the government shutdown and the fiscal deficit, the positive forces of expanding employment, rising wages and U.S. economic growth in the neighborhood of 2.5% this year provide a solid backdrop for further earnings growth. And with many stocks trading below 10 times this year’s earnings, and the S&P 500 companies averaging just over 14 times, value investors have an unusually large assortment of high quality stocks from which to choose.