Earnings estimates are falling! Earnings estimates are falling! Earnings estimates are falling! That realization isn't the result of an acorn falling from the sky. It is the result of data compiled by FactSet that has been informative and seemingly unimportant for the stock market.
Paying More for Less
The S&P 500 is up 12.6% year-to-date. It has been an extraordinary start to the year, made even more remarkable by the fact that the first quarter earnings growth estimate has been slashed from 7.3% on January 4 to -3.6% today, according to FactSet.
Looking at things from a broader standpoint, the forward twelve-month earnings estimate has been cut from $173.01 on January 1 to $171.67 today.
That dichotomous move -- prices going up and earnings estimates going down -- is the basis for what is referred to as "multiple expansion."
On January 1, the forward twelve-month P/E multiple for the S&P 500 was 14.5x. Today, it is 16.4x, which is in-line with the 5-Yr average.
In other words, investors are paying more for every dollar of S&P 500 earnings than they were on January 1, which seems hard to believe knowing earnings estimates are falling.
The stock market's belief system, however, doesn't always follow textbook form -- not on the surface anyway.
Why would one pay more for less of something? Because there is a belief better earnings estimates are coming.
From 'A' to 'C'
The stock market hasn't gone from 'A' to 'B' in terms of its earnings outlook so much as it has gone from 'A' to 'C' with 'C' being the third quarter. The first half of 2019 is essentially being written off as a temporary lull in the earnings-growth action.
To wit, first quarter earnings are expected to decline 3.6% and second quarter earnings are expected to increase just 0.1%. Third quarter earnings, meanwhile, are expected to be up 1.8% and fourth quarter earnings are expected to increase 8.1%.
The pathway to the third quarter renaissance has followed these stepping stones:
- There is optimism that a trade deal with China will get struck soon, facilitating an upward revision to earnings estimates for the second half of the year, as a trade deal is expected to restore confidence in business investment plans.
- The U.S. economy is slowing, but with the Fed stepping to the sidelines, the expansion should be prolonged and economic growth should be stronger in the second half of 2019 than what was feared before the Fed's dovish-minded pivot in early January.
- A growing number of semiconductor companies have suggested a cyclical bottom for the industry will be established in the first half of 2019 (semiconductors have leading indicator status given their widespread use in industrial applications).
- A narrative is taking root that suggests the slowdown in China's economy is slowing and that the global economy is also close to bottoming.
- The U.S. dollar has been strong because the U.S. economy has been comparatively strong, but if foreign economies start to see growth accelerate, the dollar could lose some of its appeal, leading to a weakening that bodes well for U.S. export growth and the earnings prospects for U.S. multinational companies.
- There has been a rebound in oil prices that will temper some of the negativity in earnings estimate revision trends.
What It All Means
For fundamental analysts, it is sacrilege to suggest earnings don't matter. They do -- a lot! They just don't matter as much in some situations as much as they matter in the moment that the forward-looking stock market thinks is coming.
That's why, if a company's guidance is encouraging, its stock can trade up on a bad quarterly report.
That's why a market, which appears expensive in the face of falling earnings estimates, can be defended as being attractively priced by replacing a current 'E' in the P/E multiple with an 'E' based on a better growth outlook.
That's where this stock market is right now; and the price action has provided a confirmation bias that the earnings picture is bound to improve.
That belief can keep the stock market in relatively good form, especially if interest rates remain low and the macro scare factors, like a trade deal with China unraveling, a credit event, or the Federal Reserve raising interest rates against the market's wishes, are avoided.
Earnings estimates may be falling right now, but the sky isn't falling in the stock market's mind because the present isn't accepted as a Chicken Little prologue to the brighter future that starts in the third quarter.