Why the Earnings Season Bar May Be Set Too Low
The week of April 15 to April 19 will be when earnings season kicks into full swing for major quarterly reports. Investors are looking for slower growth and what is expected to be the first real earnings decline since the second quarter of 2016. Now that tax reform is a year in the rearview mirror, management teams have been dealing with trade disputes, slower international economies, weather and other things. The S&P 500 is currently valued at 17.5 times earnings, above the historical average of 16.4.
Investors have been hearing ever more about reduced expectations for first-quarter earnings and even for guidance in 2019, but year to date the Nasdaq-100 is up nearly 20%, followed by a gain of 15% for the S&P 500 and a gain of “only” 12% for the Boeing-dominated Dow Jones industrial average. It seems more than fair to wonder if, with these gains and the macroeconomic picture with the Federal Reserve now officially on hold for rate hikes, the bias really should be this negative.
According to the Center for Financial Research & Analysis (CFRA), the consensus expectation for the S&P 500 is a 3.0% decline in earnings, and that will be an 800-basis-points drop from the 5% earnings growth that was expected as recently as January 1. What should stand out here is that this is said to be the sharpest reduction since the first quarter of 2009, which was also when the great bull market started and before the end of the Great Recession.
Other firms also have pointed to weaker earnings trends, with some mild upside expected. RBC Capital Markets recently pointed out that earnings sentiment bottomed in January. Stifel has suggested that it is too soon to expect an earnings recovery, with consensus expectations still falling for the rest of 2019. Morgan Stanley’s call is for an “earnings recession,” and the firm feels that the market, with strong double-digit percentage gains so far in 2019, is simply not prepared for the magnitude of the expected drop in earnings and only 1% growth.
FactSet noted a week ago that more companies have lowered expectations and guidance than it usually sees. FactSet also projects that eight of the 11 industries are expected to have a decline in earnings, with the only three positives being in health care, real estate and utilities. The big drop is expected in the energy sector, followed by materials and technology.
CFRA has also pointed out that the bar was lowered beyond the first quarter to include each of the following quarters in 2019. It said:
Combined, 2019 EPS growth expectations were cut from 6.5% on January 1 to 1.9% on April 10, a reduction of 461 bps. That is almost as large as the average cut recorded from January 1 to December 31 in a given year of 550 bps. Said another way, in three months and change, the index has endured 84% of the average annual reduction… We believe the lowered expectations will bode well for management teams providing or updating guidance, even if they choose to be conservative in their guidance. Among the early S&P 500 reporters, guidance has been more negative than positive, though the market is 2.7% higher since March 1. As always, investors will be keenly interested in the outlook for Q2 and the remainder of the year.
CFRA’s note showed that many companies already lowered expectations earlier this year when they released their earnings in January and February, and it further noted that the analyst community also has lowered expectations to the point that the (earnings) bar is unnecessarily low.
While all this may sound cautious, the bar seems to be set very low for first-quarter earnings expectations. When Wall Street lowers estimates by this much, investors might want to take a contrarian view and expect that perhaps the analyst community lowered the bar too much. The other issue supporting this theory would be that threat of a China trade war is still only a threat, and both China and President Trump have suggested that a “deal” would be coming soon.