Near Term Market Direction: Our Call

“Wall Street stock analysts? Meh. In a bull market, you don’t need them; in a bear market, they will kill you.” As a long time brokerage single-stock analyst, that saying has always irked me. But I also know many experienced money managers absolutely believe this weathered bit of market wisdom because it has helped them over the years.

The real problem is this: analysts and portfolio managers do two different things. The former knows managements, companies and industries and develops a fundamental view of earnings, cash flow, and industry dynamics. The latter plugs those observations into a much larger worldview that includes valuation, market sentiment, and risk management. If these two approaches happen to sync up, it is probably more accidental than anything else.

Fact-checking this sentiment at the historical peaks of prior market cycles in 2000 and 2007 shows mixed, but telling, results.

2000 experience: “True”. In the 1990s dot-com investment cycle, the S&P 500 peaked intraday at 1,553 on March 24, 2000. The future corporate earnings picture – what sell side analysts tend to focus on most – proved quite robust for several quarters to come.

  • Q1 2000 earnings (reported in April 2000) showed 19% year on year growth, with operating earnings of $13.97/share.
  • Q2 2000 earnings (reported 4 months after the market topped out) were even better, at $14.88/share, with 12.6% comps to prior year.
  • Q3 2000 earnings (over half a year after the top) still showed growth to the prior year’s third quarter, with +9.3% comps.
  • Any PM who quizzed the Street’s analysts in April 2000 (as stocks began to roll over) would have heard “But the earnings fundamentals are still good!” True enough, but equities were deflating the dot com bubble and next quarter’s earnings were irrelevant.

2007 Experience: “Mostly False”. At the top of the housing market-led rally of the mid 2000s, the S&P 500 topped out in October 2007 (1,565 at the close on the 9th, 1,576 intraday on the 11th). The earnings picture at this point was far muddier than back in 2000:

  • The S&P 500 had already failed to show double-digit earnings growth for a year, and Q3 2007 was set to deliver a 9.4% decline versus prior year results.
  • Q3 2007 earnings, which were being reported as the market topped, were 13% below Q2 2007. Some seasonality is normal in quarterly earnings, but this sequential drop was 3x larger than any other period in the mid-2000s cycle.
  • In this instance, the PM/analyst conversation would have been “Earnings feel like they are softening, and stocks suddenly feel heavy… Let me transfer you to our trading desk and they will take your sell orders…”

Fast-forward to today, and the only question that matters to US stocks is “Will earnings (and the analysts that forecast them) be ‘right’ enough to offset the headwinds of higher interest rates?” Worth noting: Wall Street sell side analysts currently have price targets that equate to a 13% increase for the S&P 500. The estimates you will see here reflect that optimism.

The sharp-eyed reader will know that revisions to expected earnings matter more to stock prices over the near term than simple growth rates. Here’s a quick review of where we stand today, courtesy of the latest FactSet Earnings Insight report (link at the end of this note):

#1: Expectations for 2018 earnings growth continue to increase this month, albeit at slower rates than in January.

  • From December 31st to January 31st, analysts increased their 2018 earnings estimates for the S&P 500 from $147/share to $155/share (a 5.4% increase in a month, a remarkable acceleration).
  • Since then, estimates for the year are only up another 1.3%, to $157/share.

#2: Many fewer companies than average are giving negative guidance for Q1 2018.

  • So far, 79 companies in the S&P 500 have issued earnings guidance for Q1.
  • Of those, 51% have given negative guidance (lower than current consensus estimates). The average percentage over the last 5 years is 74%.

#3: Based on current estimates, earnings growth momentum (almost as important as earnings revisions) should accelerate as the year progresses.The quarterly earnings comparisons look like this:

  • Q1 expected earnings growth to last year’s Q1: 17.0%
  • Q2: 18.9%
  • Q3: 20.6%
  • Q4: 16.1%
  • N.B.: the market knows these are not sustainable growth rates, largely driven as they are by tax reform and a weaker dollar. 2019 estimates call for 10% earnings growth.

Those who are negative on US stocks just now very rightly point out that by these metrics 2018 lines up very closely to the 2000 experience. Back then, stocks peaked in March even though earnings continued to grow. Now, US equities had a barnstorming January but have faltered since even though expected earnings growth is robust. In 2000, it was the dot com bubble popping that sent stocks lower. Now, investors worry that US fiscal stimulus at full employment will push long term rates much higher and force the Federal Reserve to move more aggressively than previously thought.

Given the recent volatility, we can safely label this negative view as “Consensus”, at least for the moment. That makes it worthy of scrutiny, and we have a few final thoughts:

#1: When market gets choppy, investor attention spans seem to shorten. All the potential good news from Q1 earnings seems far away indeed. Right now, the yield on the US 10 Year Treasury note, combined with Fed Funds Futures, hold the market captive.

#2: This is unlikely to change over the balance of this month. Next week sees new Fed Chair Jay Powell meet with Congress, and event that will likely suck the oxygen out of any fundamentally driven earnings story (no matter how positive).

#3: The best chance for a change in market narrative back to earnings growth is in mid-March as we draw closer to Q1 earnings season.

That makes the market direction for the remainder of the quarter something like this:

  • Weakness in US equities through the end of the month
  • Stabilization in the first half of March
  • Rally into the end of the quarter

Yes, we know calling daily/weekly market moves is a challenge, but this paradigm makes the most sense to us. While we get the inflation narrative and what it can do to bond yields, it is difficult to believe markets will ignore corporate profit growth entirely. That tension will remain for while, so future quarters will likely seesaw just like Q1 to date.

You may disagree with this approach, and that’s fine. But our bottom line in presenting this analysis is that volatility is back, and the narratives are clear. Rates and earnings, earnings and rates. Better to plan for it than to simply respond as it occurs.

“Plan your work, and work your plan” is the new “buy and hold”.

FactSet Earnings Insight Link: https://insight.factset.com/hubfs/Resources%20Section/Research%20Desk/Earnings%20Insight/EarningsInsight_021618.pdf

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