- Signal from Noise
Earnings Recession Is Here! Look Thru It
-Investors worry SPX Q2 EPS comp could be negative -But 2020 10%+ EPS growth more important -Here’s a surprise: FactSet says 2Q EPS could turn out positive From a tactical view, knowing what’s expected quarter by quarter is de rigueur. After all, you need some ammunition for those cocktail party discussions. Moreover, the headlines are blaring “earnings recession,” that is, negative earnings per share results by the S&P 500 index in two consecutive quarters. Feels scary. (In the first quarter, the companies in the S&P 500 index produced a 0.3% decline in growth.) The last time the S&P 500 saw an “earnings recession” was 3 years ago during the second quarter of 2016. What headlines don’t mention is that since then the market is up by about a third. I’m giving you our heads up on the second quarter earnings season for the S&P 500 index, which began in earnest this week. Let’s qualify this immediately by noting that what investors are expecting in the way of 2020 market EPS growth is far more important by now—past the midyear point of 2019—than 2019’s second or even third quarter, though the latter are more immediate. The market discounts the future. What’s on tap for the second period? FactSet’s estimate for the second quarter S&P 500 index EPS is negative 2.7% compared to the same period last year. Why? Analysts are worried about the challenge of both tough comps in the second quarter of 2018 (which benefitted from lowered taxes) and from moderating economy growth this year, in addition to business uncertainty caused by the various trade wars, according to Zacks Investment Research. So, the EPS headwinds are there. And there have been some misses already, by, for example, Arrow Electronics (ARW) and CSX (CSX). Both stocks fell on the news. Before getting pessimistic, however, investors should note that what analysts project at the beginning of the quarter can be different both from what they expect at the end of the quarter, and—more importantly—what turns out to be the actual earnings. (See chart.) For example, at the beginning of the first quarter analysts projected a 4% EPS drop, but it ended up being better than that. That likely contributed some to the market’s rip in the first quarter. Veteran investors know that the Sell side—in aggregate—often exaggerates the market’s current sentiment. When investors feel bearish, the analysts tend to be too pessimistic on EPS estimates. Conversely, when sentiment is euphoric, analysts feel the mojo and often come up with EPS projections that are too high or optimistic. What about now? Sentiment seems to lean somewhat to the bearish side. Yes, it’s true the market is at or near historic highs. But let’s face it, there’s no sign of excitement and really this seems the most bearish bulls I’ve seen in 30 years. Few believe in it. To make an informed judgement about quarterly earnings, a little history is needed for context instead of screaming headlines. According to FactSet, over the past five years, actual earnings reported by S&P 500 companies exceeded estimated earnings by 4.8% on average, much of that because 72% of the S&P 500 reported EPS above their respective mean estimate. Consequently, from quarter’s end through the end of the earnings season, the earnings growth rate has typically increased by 3.7 percentage points due to the upside earnings surprises. Given that, FactSet asks—and so should you: What is the likelihood the index will report an actual decline in earnings of -2.7% for the second quarter? History suggests that isn’t very high. Instead, it’s likely the index will report positive growth in earnings for Q2. But wait, isn’t everyone afraid of an “earnings recession”? If this 5-year average increase is applied to the estimated EPS Q2 decline -2.7%, the actual growth rate would be 1.0%. I repeat, positive growth. I think it’s also interesting that during the second quarter, as the EPS estimates sank, the value of the S&P 500 increased by nearly 4.8% to 2941.76 from 2834.40. That marked the fifteenth time in the past 20 quarters in which the bottom-up EPS estimate decreased during the quarter while the value of the index increased. Seems like the bull doesn’t want to die. Bottom Line: Our head of research, Tom Lee, has a 3125 year-end target for the S&P 500 index and has said that might be too low. Our technical strategist Robert Sluymer agrees. I learned long ago that what the market already knows isn’t worth knowing. Investors know that earnings for the second and third quarters of 2019 are going to be lackluster, perhaps even negative. No news there. Now maybe they will be worse than expected, and that would tend to send markets lower, temporarily. Me? I’m focused on 2020. How about you?