Earnings Recession: Get Used To It

By admin_45 in Blog Earnings Recession: Get Used To It

With Q3 2019 beginning to wind down, let’s take a look at Wall Street analysts’ earnings expectations for the third/fourth quarter of the year and 2020. All data below comes from FactSet’s Earnings Insight report:

Five key points about those numbers and what they imply about current valuations:

#1: Yes, we’re in a (slight) earnings recession and it will likely continue for the rest of 2019.

The companies of the S&P 500 reported an aggregate 0.4% decline in earnings in both Q1 and Q2 2019 as compared to the same periods last year.
Analysts currently expect Q3 to show a -3.5% decline in earnings. Assuming they continue to cut numbers through September (as is customary), even if companies beat estimates by the usual 3-4 points that will still make Q3 another negative comp to 2018.
While analysts still have a positive earnings comp in their numbers for Q4 (+3.5%, and an easy comp to Q4 2018), these numbers have been coming down all year.

Bottom line: expect 2019 to show a small decline in corporate earnings from last year. Our base case is for the S&P 500 to earn $160/share, down from last year’s $161.45/share.

#2: The core of the problem is declining margins.

In Q2 2018, for example, the S&P 500’s net margins were 12.0%. This declined to 11.5% in Q2 2019.
Nine of the 11 S&P sectors showed margin contraction in Q2 2019. The only exceptions were Financials (up 50 basis points to 17.7%) and Utilities (up 20 bp to 12.5%).

Bottom line: Corporate cost structures are out of line with current revenue growth trends. Q2, for example, saw 4.0% top line growth but that was not enough to deliver earnings growth. So far companies have avoided reducing headcount to address this problem, but that is clearly a concern going forward.

#3: Earnings estimates for 2020 seem unrealistically high.

Right now, analysts are looking for 10.9% earnings growth in 2020, from $165/share this year to $183/share next year.
This is dramatically out of step with: 1) market sentiment about the 2020 global economic outlook and 2) the thought that 11% earnings growth is possible this late in the cycle without a major catalyst.

Bottom line: while we doubt anyone is buying US equities in the belief that 2020 earnings growth will be +11%, keep in mind that Wall Street will be cutting its forward-year numbers dramatically over the balance of 2019.

#4: If our cautious stance on 2019/2020 earnings is correct, then 2014 – 2016 is the right case study to consider what this means for the direction of US stocks.

From 2014 – 2016 S&P earnings were flat, at $119/share plus or minus 31 cents.
On the plus side, the S&P managed to rally 29% from 12/31/13 to 12/31/16.
On the downside, that was only an 8.7% compounded annual return and 2015 was barely positive (+1.4% on a total return basis).

Bottom line: it is possible for stocks to gain ground in a zero earnings growth environment, but returns will be choppy. That 2018 showed an S&P 500 return of negative 4.2% fits neatly into this narrative since investors shifted gears from discounting earnings growth to what is now obvious stagnation.

#5: The 2014 – 2016 experience also lines up with current valuations and long-term interest rates.

The S&P 500 currently trades for 16.6x forward 12-month earnings, right where stock valuations were through much of 2015 and 2016.
10-year Treasury yields declined from 3.0% in January 2014 to an all-time low of 1.37% in July 2016. Now, they sit at 1.47% - not far off that level.

Bottom line: then, as now, lower rates can propel stocks higher even when earnings were flat.

The takeaway from all this: the S&P 500 has held its ground (just 3% off the highs) because investors believe 2 things:

Corporate earnings will remain stable over the next year. Yes, that is a disconnect relative to the bond market’s loud recession warnings. But equities are by nature an optimist’s game so at least this belief is “on brand”.
Lower interest rates are structural rather than temporary. From 2014 – 2016 Treasury yields declined because inflation expectations were remarkably low. The same holds true today, with 10-year TIPS breakevens at just 1.5%. Right where they averaged from 2014 – 2016, we would note.

Simply put, the S&P 500 trades right on its fair value when using the 2014 – 2016 experience as a relevant benchmark, essentially a non-expiring at-the-money call option with a 1.8% dividend. If you think a real recession is in the offing, these are great levels to sell since earnings typically decline by 10-25% during an economic contraction. Otherwise, US stocks are worth holding in the hopes of either a resolution to the US-China trade war or still-lower interest rates. We remain in this more optimistic camp.

Source:
FactSet Earnings Insight report: https://www.factset.com/hubfs/Resources%20Section/Research%20Desk/Earnings%20Insight/EarningsInsight_083019.pdf