Earnings Growth For Q2 Expected To Be 18.9%

Great Earnings Coming in Q2

The financial media acts as if the earnings reporting season is the only time that earnings matter and acts as if stocks beat estimates they should move higher. Those are incomplete understandings of earnings. Firms are expected to beat estimates, so raising guidance and beating the whisper number are more important. The aggregate earnings beats need to be above average to excite investors. We’ve already reviewed how great Q1 earnings season was based on this understanding of the results.

As I mentioned, earnings don’t just matter during the time results come out. They always matter because analysts are always updating their models and firms update their guidance in between reports. When you understand this important factor, you will become bullish on stocks because the current intra-quarter numbers look great. As you can see from the chart below, during the first two months of Q2 the bottom up earnings estimate increased 0.2% which is much better than the 10 year average which is a 3.7% decline. The estimate for Q2 earnings growth was 18.6% on March 31^st and now it is 18.9%. I think Q2 earnings growth will probably be higher than Q1’s growth which ended up at 24.6% as 77% of firms beat estimates.

Don’t worry about comparing the first two months of Q1 with the current bar because the previous quarter was helped by the tax cuts. The current quarter is better than average on the merit of economic growth which is very impressive. 60 firms have issued negative guidance and 47 firms issued positive. Even though this looks like bad news, it’s actually good news because this is better than average. The 5 year average is 72% issuing negative guidance and this quarter had 56% issuing negative guidance. Furthering the point that this quarter looks great for S&P 500 companies, revenue growth was upwardly revised from 7.8% on March 31^st to 8.6%. Even with the decline in oil prices in the past couple weeks, energy is the best sector for earnings estimates. The estimates were updated from expecting 115.7% growth on March 31^st to 136.6% growth.

Earnings Growth Is Bad?

In a previous article, I mentioned that there is a narrative that great earnings growth isn’t amazing news for stocks, but I never showed the specific results. The chart below shows that stock market performance gets better as earnings growth gets worse unless earnings decline more than 25%. I disagree with a potential takeaway from these numbers which is that earnings growth doesn’t matter. I also don’t think that bulls should root for earnings declines. These results are similar to the chart which shows when the unemployment rate is low, it’s bad for stocks. This is because when the unemployment reports are really great, it’s usually the end of the business cycle.

With earnings growth, investors are focused on future results. Because the economy is very cyclical, when growth is high, it usually doesn’t last. Even though some say the current earnings growth is “fake” because it’s based on the tax cuts, I actually think the tax cut boost is better than an economic boost because it will be sustained at least until the laws are changed. To be clear, the corporate tax cuts were made permanent, but the tax cuts on individuals and pass through corporations expire at the end of 2025. Even though earnings growth was very strong in Q1, I think economic growth will be rebounding in Q2 which will make earnings growth even better. Earnings growth should peak in Q3. Because of the tax cut, economic growth has diverged from earnings growth.

The two main explanations of this chart are that future earnings growth isn’t sustained and high earnings growth means more rate hikes. As I showed, earlier in this article, the earnings growth in Q2 will probably be better than Q1. There’s no question that 2017’s stock market performance was helped by the anticipation of tax cuts which were expected help 2018 earnings. However, even if current stock performance is based on 2019 earnings growth, I don’t think stocks are limited to 2.6% annualized gains. The tax cuts make the earnings comparisons easier to beat since they apply to 2019 earnings as well.

Secondly, the Fed won’t be hiking rates quickly even with the great earnings growth and strong economy. The tax cuts have allowed the Fed to get further away from the zero bound, but the Fed’s recent statement that it will allow inflation to get above 2% coupled with the recent year over year core PCE report showing 1.8% inflation in April show investors that the Fed won’t react hastily to strong results.

Unemployment Rate Pace

I mentioned that a low unemployment rate is usually not great for stocks. The worst situation is when the rate is low, but it is increasing because there is a lot of room for it to get worse. The unemployment rate is 3.8% which is usually a bad sign, but I think we will stay on the positive side of low unemployment as I think the rate will decrease further. The chart below shows what many investors think is impossible. If the labor force continues to grow at 151,000 per month and the job growth continues to be 215,000 per month, then the unemployment rate will fall to 3.2% next year. If we are set to see such a decrease, the stock market is fine to invest in.

Conclusion

The flattening but normal yield curve, economic growth acceleration, strong earnings growth that is sustainable, and the declining unemployment rate are all reasons to be positive on stocks. I continue to believe the S&P 500 will hit a new record high this year. I’m sticking with my cautious projection of a 5%-10% increase in 2018. I believe my bullishness is actually cautious. In continuing with my cautiousness, I will be neutral on the stock market after it hits a new record high. I am open to being bearish in 2019, but I’m not saying stocks will necessarily fall because this expansion could last longer than I expect.