by Bryan Perry
It is no secret that first-quarter earnings are going to fall a fair amount from year-ago-comparisons as well as sequentially from the fourth quarter of 2018. The latest data from FactSet predicts an earnings decline of -3.6% for the S&P, marking the first year-over-year decline since 2016. That would also mark a sharp downward revision of -7.3% from the earnings estimates when the year started.
Piling on to this dramatic lowering of profit expectations, at least 77 S&P companies have issued negative guidance for Q1 2019. Interestingly, within the analyst community, the sector with the highest level of analyst optimism is energy, a sector that delivered the fourth-best year-to-date performance (+14.2%) but one of the most unpopular investment sectors, a victim of volatile oil prices and global slowdown risk.
Back in December 2018, WTI crude was trading at $46.24 a barrel, but during the week leading up to Christmas, everything was tanking. As sentiment for a second-half 2019 recovery is starting to take hold, there is a growing acceptance that the first quarter of 2019 will define an earnings trough. Let’s hope this is the case, because the S&P is trading back up to a P/E of 16.4, which is in line with its 5-year average.
Graphs are for illustrative and discussion purposes only. Please read important disclosures at the end of this commentary.
Looking ahead, FactSet reports that analysts see low single-digit earnings growth for the second and third quarters of 2019, followed by high single-digit growth in the fourth quarter, so while investors would seem to be paying up for first-quarter earnings when they are heading down, the market is not all about the here and now, but rather a fluid narrative that is embracing both a domestic as well as global earnings rebound, six to nine months out. Investors buying this market clearly feel that better earnings are coming.
Knowing that forward earnings estimates are fluid, the most recent numbers show second-quarter earnings are expected to increase by just 0.1%, third-quarter earnings are expected to be up 1.8%, and fourth-quarter earnings are expected to increase a heftier 8.1%, which is what the current stock market rally is really embracing, driven by several factors that in and of themselves are also highly fluid.
Making a Second-Half Global Rebound Checklist
The bullish narrative fueling last week’s market surge is predicated on some open-ended situations that seem to be coming toward resolution. First, the drumbeat of a trade deal with China being finalized soon is feeding a second-half rebound narrative that will lead to a bottoming of China’s slowdown and upward revisions for earnings estimates fueled by renewed confidence and plans for more business investment.
Secondly, a reinforced Fed policy – galvanized by the 60 Minutes interview with Fed Chairman Jerome Powell – paved the way for last week’s rally on the notion that Powell’s forecast of a prolonged economic expansion will likely play out. Even with the U.S. economy currently slowing, the Fed’s new directive to be accommodative whenever and wherever necessary is a 180-degree pivot in policy that market participants hope to see resulting in fresh growth prospects during the second half of the year.
Thirdly, some green shoots in the semiconductor sector in the form of a more upbeat tone from chip and chip equipment companies suggest a cyclical bottom for the industry in the making. Because of their widespread use in industrial applications, semiconductors are seen as having “leading indicator” status.
Fourthly, the recent rise in oil prices is seen by some as a bet on second half 2019 demand picking up. Since hitting a recent bottom of $46.24 per barrel in December, WTI crude has rallied back to $58.36 as of last Friday. A clean break above $60 would signal breaking overhead resistance and a new uptrend.
Graphs are for illustrative and discussion purposes only. Please read important disclosures at the end of this commentary.
Fifth and last, the almighty dollar, which has been strong (trading to a new one-year high two weeks ago at 97.71) retreated to 96.50 on Powell’s interview and on the notion that the U.S. economy has been comparatively strong vs. other economies. However, if other economies start to see growth pick up, the dollar could lose some of its luster. If so, this condition would bode well for U.S. multinationals and export growth, which would translate into upward earnings growth and bullish analyst revisions.
Investors shouldn’t lose sight that earnings matter all the time. We’ve seen how the market’s wrath can be unloaded on companies that fail to meet Wall Street expectations when the mindset of the investment community is focused on slowing global growth. But, when investor attention pivots to a more bullish forward-looking view of economic conditions both here and abroad, the market can look past the current soft earnings projections for the current quarter and see a brighter future in outlying quarters.
This is how I would best summarize, along with others, how and why the market is rationalizing this rally when earnings projections for Q1 have deteriorated so much. Leave no doubt, there is still clear-cut risk of a trade deal with China unraveling, a hard Brexit, a negative credit event in Italy, a fresh spike in the dollar, or other macro events upsetting this narrative. And while the price action has the market feeling expensive at the moment – which is a major griping point on the financial media cable stations – the market is sending a message that the big picture, though not fully clear yet, is turning sunnier.
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