Investors Love Everything Despite Earnings Growth Decline

Investors - 2019 Earnings Expectations Are Low

2019 earnings are very interesting because of the effect comparisons will have on growth. It’s very important to differentiate between actual bad earnings and weak earnings growth rates caused by tough comparisons. 

Expectations are for just 0.65% earnings growth in Q1 2019 according to The Earnings Scout. However, growth is expected to be 10.95% in Q4. While Q4 earnings don’t come out for 11 months, which gives estimates time to fall, they still withstood the extreme pessimism from analysts in January and the first half of February. That same pessimism dragged down Q2 and Q3’s estimates to just 2.45% and 3.17% growth as the chart below shows.

Even if full year 2019 earnings growth was just 0.65%, it still wouldn’t justify the bear market of late 2018. Earnings at least need to fall to justify a bear market. 

Investors - There wasn’t a bear market in 2014-2016 even though there was an earnings recession. 

Since estimates are usually beat, I expect to see about 3% EPS growth in Q1 and 6% growth in Q2 as of today. That’s far from an earnings recession. U.S. economic growth could rebound in Q2 because there won’t be a government shutdown and trade tensions are easing. However, it’s possible the European and Chinese slowdowns get worse.

There clearly aren’t hard and fast rules to earnings growth and bear markets because stocks fell 20% in late 2018 even though it wasn’t clear earnings would fall in 2019. 

Plus, earnings growth was very strong in 2018. It’s fair to say this bear market wasn’t justified by earnings, but it still happened and we can’t ignore that. My best explanation is to say stocks should be bought when earnings estimates expect growth and fall slowly or rise. 

Stocks should be sold if estimates crash to the point where growth is negative. Then you need to add the layers of valuation analysis and economic analysis to complete your opinion.

Investors - Stocks Reacting Positively To Everything

Just because stocks rallied in January while earnings estimates cratered the most since early 2016, doesn’t mean investors ignored results relatively speaking. 

They will never ignore guidance as a whole. There can only be special instances where that rule is broken on an individual company basis. 

Year to date those reporting Q4 results and cutting guidance are up 2.65% more than the index and those raising guidance are up 7.05% more than the S&P 500 according to the Earnings Scout. Maybe investors are rewarding firms that gave guidance over those who suspended it. 

Investors are loving everything, but they still love guidance hikes over cuts.

According to FactSet, firms that reported positive Q4 earnings surprises were up 2.1% from the prior 2 days before results came out to the 2 days afterwards. 

This beat the 5 year average gain of 1%. Those missing estimates were down 0.4%, which was much better than the 5 year average change of -2.6%. 

Earnings Scout loves to mention that stocks react to guidance instead of beats, but it’s still interesting to see these results as well. The -0.4% reaction to estimate misses is the smallest decline since Q2 2009 which had a 0.2% decline. It’s amazing to see stocks acting like the economy has rebounded, when the economic data hasn’t improved much.

I think investors were way too pessimistic in December 2018 and are now way too optimistic. 

As you can see from the chart below, earnings estimates have fallen while stocks have exploded higher. The Earnings Scout compared this to the periods prior to the past 2 recessions. I disagree, because as I mentioned, earnings are still expected to grow in 2019. 

It’s more about the relative difference between estimates and stocks because this is one of the most vicious snapback rallies ever while earnings estimates have been weak. Stocks being up year to date isn’t a problem. But being up way more than earnings are expected to grow in 2019 makes them more expensive.

Investors - Revenue Still Expected To Grow During The ‘Earnings Recession’

The final point on aggregate S&P 500 estimates is the latest estimates from FactSet on Q1 2019 and the full year. 

FactSet shows that as of February 15th, analysts expect a 2.2% decline in Q1 earnings with energy and tech being the worst sectors; their earnings are expected to fall 11.2% and 10.1%. 

Q1 revenue growth is expected to be 5.3% which is down from the expectation for 6.6% growth at the end of 2018. Even the FactSet numbers, which are weaker than the Earnings Scout’s numbers, show revenue will grow in the mid-single digits. That’s not a real earnings recession.

Full year 2019 EPS is expected to grow 4.8% and revenues are expected to grow 4.9%. The biggest difference between revenue growth and EPS growth is in Q1, while Q4 will likely have higher EPS growth than revenue growth. 

It would be phony to be bearish from Q1 to Q3 and then become bullish in Q4 based on earnings growth changes because these growth rates are severely impacted by base effects.

Investors - Buyback’s Role In EPS Growth

The chart below shows net income growth depicted by the blue bars and buyback’s impact on EPS growth as the yellow bars. Both added together equals EPS growth. 

As you can see, buybacks have a small impact on EPS growth. Buybacks are usually overrated by traders. They can’t prevent an earnings recession as evidenced by the decline from 2014-2016.

Personally, as of today, I think the 2019 earnings growth slowdown will look more like 2012 than 2014 to 2016. 2012 and 2019’s earnings are being negatively impacted by weak European growth. 

The issue now is China is in a worse situation than it was in 2012. In 2012, Chinese GDP growth was 7.9%, while it’s expected to be 6.3% in 2019. The good news is the rate of change isn’t as bad because growth had fallen from 9.5% in 2011. Growth was 6.6% in 2018, implying a modest slowdown from last year is expected. 

A big issue is the cumulative effect of the multi-year slowdown as its economy struggles even with the positive impact from its fiscal stimulus.

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