Market Update – 4Q19
The stock market can defy logic sometimes — and it does so often over the course of an earnings reporting period. Companies that put up bad numbers see their stocks trade up while companies that put up good numbers see their stocks trade down. One thing that rarely defies logic, however, is the marking down of earnings estimates prior to the start of a reporting period. It happens all the time, as analysts usually hope for the best when the quarter starts and prepare for the worst, in a manner of speaking, as the quarter comes to an end. In doing so, they almost always lower the earnings growth bar to a point that makes it easy to hurdle. The third quarter earnings reporting period, which kicks off in the coming week, should be no different.
Looking at the Bright Side
According to FactSet, the third quarter earnings growth estimate stood at -0.6% on June 30. Today, it sits (but doesn’t rest) at -4.6%. Growth estimates for every sector have come down since the end of the second quarter, triggered by incoming economic data from around the globe that has been weaker than expected, a drop in energy prices, a flattening/inverted yield curve, rising labor costs, a strong dollar, and a heightened sense of trade uncertainty that has eroded business confidence and business spending. Fortunately, the U.S. consumer has been a mainstay of strength, but even that hasn’t been enough to sustain starting earnings growth estimates. The specter of higher tariff rates has factored into downward revisions for many consumer discretionary companies along with curtailed tourist activity in major cities and secular shifts in consumer buying patterns from offline to online. In considering the broad-based earnings revisions, the most remarkable element perhaps is that the S&P 500 increased in the third quarter while the earnings estimates came down. FactSet informs us that the S&P 500 increased 1.2% in the third quarter while the bottom-up EPS estimate dropped by 3.6%. If stock prices are driven by earnings, then let it be said that they bypassed the drab view and decided to look at the bright side in the third quarter.
Wait until Next Year
The stock market managed to remain resilient in the face of declining earnings estimates for a variety of reasons, the most pertinent of which was the further decline in interest rates that was driven by further policy accommodation on the part of the ECB and Federal Reserve. It wasn’t just about interest rates, however. There was an appreciation for the relative strength of the U.S. economy — the U.S. consumer in particular — along with an abiding hope that a trade deal between the U.S. and China would eventually be struck. Said another way, nothing really changed in terms of the stock market’s prevailing disposition. Granted there was some increased volatility in the third quarter, yet the S&P 500 exited the quarter up 18.7% for the year, and less than 2% away from its all-time high, despite a lack of earnings growth. Earnings in the first and second quarters were down 0.2% and 0.05%, respectively, according to FactSet data, so the third quarter earnings growth forecast has the market on track for its third straight quarterly decline. The price gains in the absence of earnings growth is predicated on the belief that earnings prospects next year will be much improved. That expectation has been validated by the consensus estimate, which calls for 10.6% growth for 2020. That’s a big ask, yet it is the basis for rationalizing a big move in the market now when there is no earnings growth to back it up.
What This Means to You
With the latter in mind, it leaves us to wonder if the third quarter results will matter all that much to the market. To be sure, market participants have seen enough reporting through the years to know that the final growth rate is apt to be three to four percentage points better than the estimated growth rate just before the start of the reporting period. That won’t get the third quarter “growth” rate back to positive, but it would keep it close to flat like the first and second quarters, both of which were cheered for being better than expected (but were really just better than the downward revisions). This reporting period, however, is an important load factor for the market, as companies will be providing their guidance for the fourth quarter, and, in some instances, giving glimpses of their FY20 outlook. One can expect to hear “trade/tariff uncertainty” a lot in the rendering of earnings forecasts. How the market reacts to that could ultimately boil down to the cues it gets from the White House on trade matters, not just with China but the EU as well, and to what the economic releases are revealing about the state of the U.S. consumer. Per usual, the reporting season will get going with the financial sector leading the way. The coming week, however, will also feature reports from the likes of UnitedHealth (UNH), Johnson & Johnson (JNJ), United Airlines (UAL), Alcoa (AA), CSX Corp. (CSX), IBM (IBM), Netflix (NFLX), Honeywell (HON), and Union Pacific (UNP). Those reports can, and should, move the market, which has been moved quite a bit this year by earnings growth optimism for 2020 in the face of no earnings growth in 2019.
As always, I look forward to hearing your comments and questions.
John P. Swift, CFA, CPA
CEO & Chief Investment Officer