The Market Is Reveling In Great Q1 Earnings

The stock market had the tailwind of Macron’s victory at its back, but it didn’t rally Monday morning. As I was predicting from a few weeks ago Macron, the centrist investment banker, won the French presidential election in a landslide. Macron received 66.1% and Le Pen received 33.9% which was below what most of the pollsters had her getting. The next step is the French parliamentary elections in early and mid-June. It’s not necessary to get into the weeds of the French political system because I doubt the market will be concerned with whether Macron can govern or there’s a stalemate between opposing factions and little is done. The main concern the market had was with the risk of Le Pen getting elected and ending the European Union. Now that that’s over we can get back to focusing on American corporate earnings.

Q1 corporate earnings have been amazing thus far. Operating earnings have beaten expectations by an average of 6.2%. That’s above the one-year average which is 4.3% and the five-year average which is 4.1%. The chart below shows operating earnings were up 13.5% which beat expectations for 9.0% growth. That’s the highest year over year growth since Q3 2011 when earnings grew 16.7%. As you can see, the only sector which missed estimates was telecom. The financials were the top performer as the weakness in lending growth has not caught up to them. If this weak lending growth continues and delinquencies rise, the earnings growth won’t continue. The financials have the tailwind of the Fed raising rates which improves their net operating margins.

Operating margins are what drove these great results. As of May 4th, the blended (actual and estimates) operating margins for Q1 were 10.06%. The peak of this cycle saw 10.10% operating margins. This quarter would be the third best of this cycle, with the best two being Q2 and Q3 2014. If next quarter’s margins improve, it would disprove my projection that margins will not make new highs. The chart below uses FactSet’s S&P 500 trailing net margins. Even though this is a trailing metric, the results show it to be a leading indicator. It would be even better if you looked quarterly data. The problem with using this indicator for this cycle is margins have fallen since 2014, but it’s been a false alarm as there’s been no recession.

This cycle is much different from most as it has been weak and long. This is the 3rd longest recovery since 1854 as it has lasted 95 months. The second longest recovery was 106 months in the 1960s and the longest was 120 months which lasted from the early 1990s to the early 2000s. The chart below shows Goldman Sachs’ recession probability forecast. Using the probabilities given in the prior cycles, it looks like the next recession is coming in about two years. This, of course, isn’t a perfect indicator. Goldman Sachs economists are claiming that the low unemployment rate will cause the labor market to heat up, but that hasn’t happened yet. Even though the unemployment rate is 4.4%, there hasn’t been accelerated hourly wage growth. The next recession won’t be caused by too many people getting jobs; it will be caused by the excess leverage collapsing the system. That’s why I focus on the delinquency rates to understand the credit cycle. If low interest rates didn’t cause excess debt to be taken on, I would not expect the low unemployment rate to lead to a severe recession.

In 2007, operating margins peaked at 9.23% for the year, while the height of this cycle was 9.76% in 2014. I’m expecting decelerated earnings growth and margins for rest of the year as 10.06% is likely unsustainable. On an as reported basis, earnings growth was even higher than on an operating basis. Sales only grew 6.77% year over year, but the increased margins led to a 29.3% increase in earnings as they went up from $21.72 in Q1 2016 to $28.09. The 73.84% earnings beat rate is the highest rate going back until Q2 2013. I don’t have the data from before then. The second-best beat rate was Q3 2014 which was the peak in trailing twelve month earnings for the cycle. That quarter had record high bottom-up earnings before this quarter beat it. Q3 2017 is expected to set a new trailing twelve-month record for bottom-up earnings.

There are 87 companies in the S&P 500 which still must report their earnings. The aggregate results probably won’t change dramatically in the next few weeks when earnings season wraps up. 25 of the 87 companies which have yet to report are in retail. So far, 77.55% of consumer discretionary firms have beat their earnings estimates which seems to imply the rest of the retail results will be good. 57.65% of consumer discretionary firms have reported earnings which is the lowest for any sector. As you can see from the chart above, operating earnings have grown 3.5% which is 5.3% better than the 1.8% decline expected.

The chart below shows the sub-industry earnings growth from retail firms. Even with the rolling over of the auto bubble, the automotive retail subset eked out 0.8% gains. Unsurprisingly, home improvement and food distributors are doing well and apparel isn’t. Malls are switching from apparel firms to restaurants as restaurants offer longer lease agreements and act as an experience which brings in customers. Online retail continues to trounce gross merchandise stores as logistical improvements improve shipping speeds making it more convenient than having to go to the store to buy something.

Conclusion

Earnings season for Q1 is almost over. It had record high earnings as margins almost hit new highs. The bears’ main argument in 2016 was the decline in earnings, but that argument has been taken away. The high margins aren’t necessarily a buy signal because they’re cyclical. There needs to be a turn in margins for stocks to enter a bear market. The decelerating loan growth suggests that turn could happen this year, but Goldman’s recession indicator puts a turn off for at least another 12 months.

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