Why Things Feel So Horrible

If you’ve never worked as a sell side stock analyst, Wall Street’s earnings estimates machine may seem like a black box. I suspect most investors believe EPS estimates to be the mathematical output of complex earnings models, carefully updated with the latest macro/micro inputs. Analysts’ tweaks to those calculations through time then filter into the market’s take of future corporate earnings and bubble up to consensus estimates of what the S&P 500 might earn in the future.

I was a sell side analyst for the better part of a decade at Credit Suisse and have many friends still in the business, so I can tell you the truth about earnings estimates is quite different. Here is how it actually works in 99% of the cases (the other 1% being special situations/workouts/M&A names):

  • Good analysts know the only thing that matters to their estimate is incremental revenues and margins. The market knows about the near past for these inputs. Their job is to forecast the near future.
  • The questions they ask: how quickly are revenues rising or falling? How do those flow through an income statement model, given the percentage of fixed/variable costs? And what is going on with pricing, which usually carries 100% incremental margin contribution and can make or break an earnings estimate?
  • Incremental margins are generally easier to predict in the middle of an economic cycle, when business conditions are stable.
  • At the bottom and top of cycles, they become much harder to model. That is because every contributor to margin performance becomes non-linear. Pricing power changes quickly, for good or for bad, and fixed cost structures are either very lean (at a bottom) or bloated (at a top).

No prizes for where we are in terms of business cycles: markets are signaling a top. That puts us in the danger zone for both analysts’ downward revisions and earnings misses/lower guidance once companies start to report current quarter results.

The latest data from FactSet’s Earnings Insight Report (dated Friday 12/14) shows this dynamic playing out in real time:

  • Wall Street analysts continue to cut their Q4 earnings estimates and now expect 12.8% growth versus last year’s Q4. At the start of the current quarter, they were looking for 16.7% growth. That current 12.8% expected increase is the lowest forecast growth rate so far in Q4.
  • FactSet notes that these Q4 earnings cuts are in line with seasonal norms. Analysts typically true-up overly optimistic annual EPS estimates by cutting Q4 numbers as the year winds down. The current cuts amount to a 3.2% decline in earnings expectations; the average over the last 15 years is 3.9%.
  • Here’s why that seasonal explanation doesn’t matter just now: analysts are looking for much slower revenue growth in Q4 (just 6.5%) versus Q3 (which came in at 9.3%). Q4 is also expected to be slower than Q1 (+8.5% revenue growth) and Q2 (+10.1%). That fits with the current market narrative of slowing global growth, of course.

The bottom line here is that we expect further cuts to Q4 earnings expectations right into the kickoff for earnings season in January 2019. There’s more than seasonal trends afoot; revenue growth expectations are declining and much lower than Q1 – Q3.

Then there is the important issue of 2019 earnings estimates, which analysts continue to cut but not by enough to fit current business conditions. The consensus is still looking for 5.2% revenue growth and 8.3% earnings growth. This implies positive incremental margins, something that seems overly optimistic at this point in the cycle.

What all this means for US equity markets right now: there are good fundamental reasons to explain why US equities continue to struggle. Three thoughts here:

  • Analysts have thus far left their 2019 earnings estimates pretty much unchanged at $176/share even as they have chipped away at their Q4 numbers. That makes the S&P look cheap at 14.5x earnings.
  • Investors are clearly worried that this number will end up looking more like $160/share (this year’s earnings) or a little lower. Remember our incremental margin discussion – these are very hard to call at the top of a cycle.
  • That leaves the S&P trading for a “real” multiple of 16.0x past-cycle peak earnings, which looks less attractive.

Source: https://www.factset.com/hubfs/Resources%20Section/Research%20Desk/Earnings%20Insight/EarningsInsight_121418.pdf