– Don’t Fear 4Q19 SPX EPS decline; market has already discounted it looking to 2020
– Preliminary U.S.-China trade deal, fading impeachment should ease 2019 headwinds
– Expectations of 10%+ SPX growth should propel markets higher
This time 12 months ago, “earnings recession” fears were in full bloom among U.S. investors. Well, the recession came but the market ignored it and looked ahead, hence the nearly 30% rise in the Standard & Poor’s 500 index (SPX) in 2019. Indeed, depending on which data provider you use, the 4Q19 EPS season beginning this week will likely mark the third or possibly fourth consecutive quarter of EPS declines for the SPX.
Is that worrisome? Not really. It looks to me that investors are already looking forward to the earnings growth in 2020, when comparisons (to 2019) will be easier. While the 4Q19 EPS results won’t be great, they are still likely to be better than currently expected. That should bolster already strong market sentiment as we move into 1Q20.
The stock market is a discounting machine. I believe one of the reasons investors have ignored 2019’s pedestrian earnings growth—effectively flat on 2018’s $161 per share—was that 2018’s numbers were artificially higher than they otherwise might have been, thanks to the Federal government’s big corporate tax cut in late 2017.
It wasn’t an apples-to-apples comparison. Hence, when the reason that corporate America’s profits growth is “depressed” is synthetic, and government made, investors adjust and discount it.
Of course, earnings growth is key, perhaps the most important factor in valuations, as they teach you in portfolio school. As we’ve noted in our pages recently from colleague Tom Lee, unlike last year, SPX EPS growth is likely to be far more important in 2020. Despite flat SPX’s earnings last year, the market rocketed nearly 30% ahead. In 2018, earnings rose more than 20% but the SPX fell.
I’ve included a chart from Tom Lee which is well worth consulting. It shows concisely that in the shorter term sometimes the market discounts the E in the price/earnings concurrently (P/E) and sometimes not. And it’s likely that, after mostly ignoring the Standard & Poor’s 500 index EPS growth last year—or lack thereof—thanks to the back and forth in U.S.-China trade tensions and the impeachment of President Donald Trump, investors seem to have lowered the temperature on those concerns in 2020.
What is the forecast for 4Q19 EPS growth? The estimated earnings decline for the S&P 500 is currently -2.0%, according to FactSet, compared to an estimated 2.5% back on Sept. 30. Of the 107 companies that have issued guidance, 73 have issued negative EPS guidance and 34 positive. That sounds bad but it’s not. Negative guidance issuance is slightly below the five-year average (75), while positive guidance is slightly above the five-year average (32).
A smaller percentage of SPX companies have lowered the bar for 4Q EPS relative to the recent averages. I think this is a healthy reflection of companies already going into a more normal environment for EPS growth, and more confidence that the U.S. economy will keep growing—if at a more leisurely pace than we’d all like.
Here’s some more history that could be instructive. According to Bespoke Investment Group: One key difference between this 4Q19 earnings season and recent quarters is that although analysts are still lowering EPS forecasts on more of the companies they cover than raising forecasts, the spread isn’t nearly as negative. Over the last four weeks, the spread was a net -61 or 4.1% of the stocks in the S&P 1500 index, the least negative reading in the last six quarters.
This looks like a classic case of setting the bar low, so that companies can “beat and raise.” More often than not, when the expectations are low for earnings season (negative spread), the SPX sees a positive performance during earnings season. Conversely, when the bar is set high heading into earnings season (positive spread), the market has struggled during the reporting period into earnings season. That’s straightforward. If too high expectations aren’t met, then stocks fall.
Indeed, the best SPX performance comes when the net revisions spread is negative heading into earning season, as it is now. In 35 prior such cases since 2009, the SPX had a median gain of 2.6% in the quarter with positive returns 80% of the time.
With the headwinds in 2019 discussed above, earnings growth was weak but now economic growth, and with it EPS, will fare much better in 2020, with the trade deals in place and with Boeing, for example, eventually getting back to producing planes. Already, big banks, like JP Morgan Chase (JPM), have already reported strong fourth quarter numbers this week.
In 2020 comps will be easy, and we see EPS growing 10%+, with stock prices possibly doing better than that. However, I’ll add that there could be some temporary choppiness in the first quarter 2020 as various technical short-term indicators are extended, according to Robert Sluymer, our head of technical strategy.
Where I could be wrong: The economy could sputter and new headwinds emerge that put a damper on EPS growth.
Bottom Line: The new 4Q19 reporting season might show EPS slightly negative, but I think that final numbers are likely to prove better than expected, with enough positive surprises to keep the market’s chin up.