Earnings Beat Rate Was 74.01% In Q1 (Highest Since At Least Q2 2013)

In this article, I will discuss some more of the details of the aggregate earnings reports as of May 22nd. Unsurprisingly, energy is the sector which is expected to have the highest projected annual 5-year earnings growth rate. This isn’t surprising because the sector is starting from a low base. Some of that growth is in the sector’s own hands because it can cut costs and discover more oil and gas. However, much of the profit growth depends on oil prices. This is dicey because Chinese demand could fall if it’s leverage becomes a problem. It also depends on OPEC’s long-term decision on cuts. It seems unlikely that the cuts will last 5 years which could mean pressure on prices in the future. This uncertainty is likely why the sector has the second lowest PEG which is 1.17.

Another interesting sector worth focusing on is small cap financials. Small cap financials are only expected to have annual earnings growth of 11.12% over the next 5 years. This is highly dependent on the Fed’s interest rate decisions, the deregulation of the banks, and the tax cuts. The KBW regional bank index was the top bet on the Trump presidency because of his initial promise to repeal Dodd Frank which has been strangling the small banks. Since March 1st the index has fallen 13% as confidence in deregulation and tax cuts passing has waned. The Fed has done its part by raising rates in March and guiding for a rate hike in June.

In my last analysis of the S&P Dow Jones earnings reports, I noted that the beat rate on earnings was the highest since Q2 2013, at least. That record continues to be true. It fell slightly, but 74.01% of firms beating expectations is still the highest since Q2 2013. The two sectors with the highest beat rates were healthcare and financials, with rates of 83.93% and 83.08% respectively. It’s interesting to see financials underperforming lately. The selloff may be because of the potential change in the credit cycle which I will review in my next article.

The aggregate year over year share count reduction rate wasn’t as great as it has been in the recent past likely because of the lagging effect from the earnings recession. 56.6% of S&P 500 firms had lower share counts than Q1 2016 and 42.1% had higher share counts. 14.1% of firms shrunk their float by 4% or more. That’s the lowest rate since at least Q4 2014. The rate has been declining since Q1 2016 when it peaked at 28.17%. Inversely, the percentage of firms increasing their float by 4% or more has been increasing since Q3 2016. 12.21% of firms increased their share count by 4% or more in Q1 2017 compared to only 6.04% in Q4 2014.

Total sales growth for Q1 was 6.88%. This was driven by energy and financials which had 32.96% growth and 28.73% growth respectively. The total sales growth rate is sustainable. What is unsustainable is the 13.35% year over year margin growth rate. I wouldn’t expect analysts to predict a recession, but it would make more sense to project plateauing margins instead of growing from this elevated rate.

As I mentioned previously, the improvement in the European economy versus the weakness in the American economy is helping large cap firms and hurting small cap ones. Five of the eleven Dow companies reported year over year revenue growth in Europe which is the highest amount since Q3 2014 which was the peak in trailing twelve-month earnings. The chart below breaks down some of the Dow firms’ revenue growth rates in Europe. Apple led the way as its European strength helped balance out weakness in China.

The chart below is from FactSet. It breaks down the sector by sector earnings growth projections for Q2. With most firms having reported their Q1 results, we have a good idea where the Q2 results will be. The changes in the estimates in the next few weeks will be based on economic reports, channel checks, and any earnings pre-announcements. The year over year growth rate will not be as high as last quarter unless there’s even more beats than last quarter because expectations are lower. As you can see, year over year operating earnings growth expectations have come down from 8.6% on March 31st to 6.8%. That’s mostly driven by the drop in energy growth expectations. Q1 2017 was the first quarter of normalized earnings for energy, so the rapid growth rate due to easy comparisons will continue until Q4 2017. Energy earnings contributed -2.43% to S&P 500 earnings in Q2 2016; the projection for Q2 2017 is for a 3.66% contribution.

 

The chart below shows the previous changes to earnings expectations in Q1 and Q2. The sharp decline in Q1 came in January. The equivalent month would be April for Q2. There wasn’t as large of a dip in April for Q2 as there was in January for Q1. Usually there is a sharp dip in expectations right before earnings are reported. The fact that there wasn’t much of a dip in Q1 may have been a signal that a good reporting period was coming. I will be watching how the analysts change their expectations in June to tell how Q2 will turn out. Even if this indicator doesn’t act as a predictor of future results, it still would be a positive to see another quarter where estimates aren’t revised lower right before earnings season.

Conclusion

The details of Q1 earnings were good. They are the reason why stocks have risen in April and May. Even with the large one day selloff in stocks at the end of the month, the S&P 500 closed up 1.16% in May. The rising corporate profit margins combined with weak economic data is why stocks can rally to record highs while the bond market also rallies. The 10-year bond yield has fallen to 2.1993%. The ten-year bond minus the two-year bond is 0.9215%, signaling the economic recovery is ending. The Fed raising rates could accelerate the timetable for the next recession.

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