Earnings Recession: Get Used To It

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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.

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