24.5% Earnings Growth Is Bullish For Stocks

93% Of Firms Have Reported Q1 Results

According to FactSet, 93% of S&P 500 firms have reported earnings. These firms have a blended earnings growth rate of 24.5% as 77% have beaten sales estimates and 78% have beaten earnings estimates. If the 78% beat rate holds up, it will be the highest beat rate since FactSet started tracking the metric in Q3 2008. The chart below extends the data back further to Q4 1994. The clear trend is towards beating earnings estimates more frequently. Trends during this period which helped results are the decline in the tax rate and rising margins. However, actual earnings improvements aren’t responsible for this trend. There has been a lowering of the bar because firms have recognized how important it is to beat estimates.

Earnings Beats Don’t Mean Everything Is Perfect

Unfortunately, for these firms there’s no free lunch. Firms can’t just facilitate beats artificially to pump up the stock. Everyone knows when analysts lower the bar beforehand. Sometimes the headlines get tricked up by saying the result was a beat, but short sellers are always quick to correct the record. There are examples of stocks beating lowered estimates and going up, but this isn’t the norm. Either these firms still reported impressive results because the bar was still high after it was lowered right before the quarter or the stock is likely overvalued.

The most prominent example of a company reporting genuinely bad results which beat estimates because the bar was lowered was Tesla’s recent quarter. As of October 31^st 2016, the earnings estimate was a 27 cent loss. Then on December 29^th, 2017 the earnings estimate was a loss of $2.02. On earnings day the firm reported a 23 cent “beat” of the estimates as EPS came in at $3.35. These results actually missed the estimates from October 2016 to March 2018. To be clear, investors looking at the results cared more about deliveries than profits since profitability has only been promised after the production rate reaches a certain threshold.

As you can see, a firm which is losing money and missing estimates from a couple months prior can still beat estimates on earnings day. There will likely be a wholesale change in the way these results are calculated in the future. The best ways you can combat this issue is by looking at the earnings whisper which can be a better representation of what the market expects firms to produce, looking at the earnings estimate history, and looking how results cause analysts to change their forecasts for the next quarter. In the future, the S&P 500 earnings beat rate should look at estimates from 3 months prior because there will be a point where almost 100% of firms beat analysts’ results.

Q1 Was Great Even Pre-Tax

The chart below compares Q1 with the historical first quarter estimates. As you can see, the estimates fall prior to the quarter and then the blended average moves up as the firms beat the lowered expectations. The final result is slightly higher than the estimates from 64 days before the quarter started. If those were the estimates used, the earnings beat rate would be closer to 50% than it has been in the past few years. Even during the worst quarter of the financial crisis, the beat rate was above 40%. That wasn’t a quarter with slightly below average results; it was a disaster. As you can see, unlike other quarters which had high beat rates which were mostly brought about by lowered expectations, this quarter had great results as the bar was raised before results came out. Even pre-tax income was up 10%; net income was up 16%. Excluding energy, pre-tax income was up 9% which followed a 0.8% increase in Q4.

Earnings Growth Isn’t Bad

It’s amazing how narratives can change based on a few weeks of market returns. No matter what the recent trend is, the results are extrapolated indefinitely as if a new reality has been determined. This explains how analysts and investors got widely bullish in the late 1990s on tech stocks and how real estate investors got so bullish in the early 2000s. If a trend happens for a week, it is a new story. If it happens for a few years, it’s the law of the land even if it’s a bubble. This situation can happen on both sides (bullish and bearish) as trend extrapolators don’t use critical thinking.

One example of this is how investors have decided that great earnings growth is bad because the stock market did poorly during most of the Q1 earnings season. Good results have become bad just because of a few poor weeks in the stock market. The S&P 500 is up in the past couple weeks and the Russell 2000 is at a record high, so it will be tough to justify that prior narrative if the recent run continues. Luckily, the narrative shifts like a flag in the wind. Earnings growth isn’t like the unemployment rate where good news is bad news because higher earnings don’t necessarily mean inflation. Technically, the low unemployment rate hasn’t meant inflation either in this cycle, but I’m referring to prior cycles.

Generally, high earnings growth occurs at the beginning of the cycle because the comparisons are the easiest. The data shown to support the fact that high earnings growth is bad is performance has been historically weak when earnings growth is above 20% and it’s great when results are between -10% and 10%. I find that range to unmanageable as a 10% decline is poor and a 10% increase is great.

The chart below shows the data in a better light in my opinion. As you can see, when earnings growth was above 10% the average S&P 500 returns since 1991 were 16.7%. The market was up 12 out of 12 times. When earnings growth was negative, returns were 1.8% per year as only 60% were positive. To be clear, the earnings estimates for 2018 listed below are way too low as the current estimate is for $160.45 (growth of 19.4%). This furthers the point that earnings growth will be above 10%. I’m not even expecting stocks to return 16.7% this year, showing you how conservative I am in my bullishness.