What's wrong with this picture? S&P 500 earnings increased 25% in the first quarter, 25% in the second quarter, 26% in the third quarter, and are forecast to increase 10.6% in the fourth quarter, according to FactSet, yet the S&P 500 declined 6.2% in 2018 following a calamitous month of December in which it fell as much as 14.8%.
Earnings drive stock prices, so how come stock prices were driven into the ground last year on the back of record earnings growth?
That is the question. The answer is that the market's forward-looking nature got the better of it.
From our vantage point, the correction was one part fundamental, one part technical, and in large part psychological.
What the market feared took over as a price driver -- and the market seemingly found a lot to fear, all of which got wrapped up in the prevailing narrative that earnings growth in 2019 was destined to be lackluster and maybe even negative.
What was weighing so heavily on the market's mind in the fourth quarter?
- It was worried about the Federal Reserve killing the U.S. economy with an aggressive monetary policy stance.
- It was worried about trade friction between the U.S. and China forestalling capital investment plans.
- It was worried about a slowdown in foreign economies, namely China and the European Union, spilling over to the U.S.
- It was worried about a strengthening U.S. dollar crimping earnings prospects for multinational companies.
- It was worried about the message of a flattening yield curve.
- It was worried about difficult growth comparisons in 2019 as the initial impact of the fiscal stimulus faded.
- It was worried about political friction in the U.S. standing in the way of market-friendly policies.
- It was worried about the stock market sell-off zapping consumer and business confidence
That's a lot of worries. We're worried we didn't capture them all, but we'll move on since worrying is like a rocking chair -- it gives you something to do but gets you nowhere.1
In a certain respect, the market has already moved on from the fourth quarter earnings reports.
Arguably, those reports are irrelevant considering the price action leading up to the reports -- and we're not talking about the 10% rally off the December 24 low. We're talking about the 20% decline from the September 21 high that unfolded despite third quarter earnings growth that was the highest for any quarter since the third quarter of 2010.
What the market effectively did in the fourth quarter sell-off was front run a downward revision to 2019 earnings estimates. It was a sprint, too.
The S&P 500 declined 14% in the fourth quarter while the 2019 consensus earnings estimate fell by only 2.3% to $173.94, according to FactSet. That's why you hear today that there was multiple compression since the "P" in the PE ratio declined more sharply than the "E."
The question that will be answered in the fourth quarter reporting period is whether the corporate guidance implies the market ran too far with its earnings worries.
An Abnormal Twist
In a "normal" environment, one should be quite happy to see 10.6% earnings growth for the S&P 500. That's the current fourth quarter forecast for the S&P 500. The abnormal twist for the market is that fourth quarter earnings growth was expected to be 16.7% at the start of the fourth quarter, according to FactSet.
The earnings growth itself is fine, but it is the trend in the estimate revision for the fourth quarter, and the expected trend for future quarters, that has bothered the market.
Every sector has seen earnings growth estimates get marked down since the start of the fourth quarter, but only one sector -- utilities -- is expected to see a year-over-year decline in earnings growth.
The energy sector is expected to lead the way with 73.0% earnings growth in the fourth quarter, yet analysts are expecting an appreciable slowdown for energy sector earnings in 2019, evidenced by a full-year forecast for a 0.1% decline that some think is still too high considering the plunge in oil prices and slowdown in economic activity.
Fourth quarter earnings growth for the remaining sectors ranges from (5.5%) for the utilities sector to 14.4% for the industrials sector. S&P 500 revenue growth, meanwhile, is projected to be 5.9% in the fourth quarter, with growth estimates ranging from (0.7%) for the utilities sector to 20.3% for the communication services sector.
If the earnings reporting holds true to historical form, fourth quarter S&P 500 earnings should be closer to 15% when it is all said and done. Again, that's quite good, but again, that's quite in the rearview mirror for market participants.
The December employment report on January 4 helped turn the tide of negative sentiment about economic and earnings growth prospects. An acknowledgment that same day from Fed Chair Jerome Powell that the Fed will be patient with its policy approach did, too.
We're calling that the born-again moment for the "Fed put," as the stock market has been lifted up greatly ever since by Mr. Powell's dovish-minded assurance.
In any event, there has been an allowance in the stock market since January 4 -- but really since December 24 -- that earnings growth estimates for 2019 won't get marked down as much as some people thought. It didn't hurt either that the trade talks among deputy officials from the U.S. and China reportedly went well, creating some hope that a worst-case tariff scenario will be avoided, which would be a good thing for business confidence and 2019 earnings prospects.
Time will have to tell on the latter point, but in the meantime, it will be the companies doing the talking that will create an inflection point for the S&P 500 and its ability to pass through 2600 with some born-again swagger or return to its fourth quarter purgatory.
The potential excuses for disappointing guidance are stacking up, which is why expectations are on the low side going into the fourth quarter reporting period.
From Brexit uncertainty to the partial government shutdown to market volatility to a slowdown in foreign economies, the excuses cut far and wide. Uncertainty, however, may just be the go-to excuse in a bid to temper earnings expectations.
What It All Means
Investors will need to pay close attention to why a company may be issuing a sales and/or earnings warning, because there are a lot of macro factors companies can hide behind to mask what just might be company-specific issues.
Companies that guide up, like General Motors (GM), should see the benefit of outsized gains, whereas, companies that guide down are at risk of seeing their stocks fizzle out.
This reporting period, therefore, should be a discriminating one where winners win, and losers lose. What that ultimately means for the broader market's performance boils down to who are the winners and who are the losers. To wit, Amazon (AMZN) and Boeing (BA) "winning" creates an entirely different trading context than does Duke Energy (DUK) and Procter & Gamble (PG) "winning."
Ideally, everyone wins, yet that's looking increasingly impractical given the warnings that have already been heard from Apple (AAPL), American Airlines (AAL), Macy's (M), Constellation Brands (STZ), Micron (MU), Carnival (CCL), and FedEx (FDX) to name a few.
Earnings growth will be slowing naturally. Tough comparisons assure that and softening economic data suggest it.
FactSet informs us that analysts are projecting 6.9% earnings growth for 2019, down from what is expected to be 20.1% earnings growth for 2018.
Might as well get comfortable on the couch. A market psychology session is about to start, and it will be a soul-searching one for a market that is anxious to find out if its earnings worries are real or an overstated figment of its imagination.
1 Borrowed from a sign in the office of my wife who is a clinical child psychologist