Q4 Earnings Look Great So Far
Last week the FactSet aggregate S&P 500 calculations were severely altered by Citigroup’s one time loss related to the tax cut. This week FactSet changed the numbers as they calculated Citigroup’s earnings to be $1.28 instead of -$7.15. This excludes the one time write off related to the tax cut. This changed the S&P 500’s blended EPS growth from -0.2% to 11.7%. This is the ultimate proof that the earnings write offs from Q4 will be swept under the rug. It’s a great deal for stock investors as no one seems to care about the write offs and everyone is paying up for stocks based on the tax cut helping increase future earnings. This is representative of the optimistic sentiment in the market. When investors are pessimistic, they focus on every negative and when they are optimistic, they only focus on the positives. This is what makes investing frustrating because one day an indicator/event matters and the next day it’s ignored. Therefore, it’s good to have your own opinion on what matters, to avoid the noise. You will be like a cat chasing its tail if you always focus on the last thing Wall Street cared about.
Since FactSet is ignoring the one time weakness at Citigroup, the earnings estimates for the quarter improved. One stat which hasn’t been messed with that much is the positive revenue surprises. As you can see from the chart below, 81% of firms have beaten revenue guidance. If this surprise rate holds, it would be the highest total since at least Q3 2008 when FactSet started calculating the results. This is 21% higher than the 5 year average beat rate. As of January 25th, 24% of firms had reported results. This week will be the biggest week of earnings season as many mega cap tech names will be reporting.
The chart below shows the expectation for revenue growth in the past 4 months. There was never a decline in estimates prior to the reporting period like usual. This makes the revenue beats even more impressive. The bar wasn’t lowered and companies are stepping over it easily. Most firms have yet to report, but the results so far justify the stock market rally. They needed to come in good because stocks rallied in anticipation of great results. I also think the economy is becoming a slight negative for stocks, which earnings need to make up for. The results from many of the January reports have been middling which is unacceptable for a market which is having one of the best starts to a year ever.
It’s no surprise that the future earnings estimates were pushed higher because analysts are still calculating the final effects of the tax cut. I don’t expect the estimates to fully reflect the tax cut until after this earnings season is completed in a few weeks. Analysts key off full year company guidance when making their projections. This is one of the reasons analysts usually start the year expecting high growth. I’m worried about 2019 earnings because 2017 was boosted by a cyclical economic improvement and 2018 will be boosted by the tax cut. What will 2019 be helped by to catalyze the implied 10.45% earnings growth? As I showed in a chart in a previous article, it’s difficult for earnings growth to consistently stay in the double digits.
Revisions The Highest Ever
As you can see from the chart below, the 1 month earnings revisions are by far the best in the past 30 years. This future earnings growth pushes forward earnings multiples down. If you take the 2019 earnings estimate at face value, the 2019 S&P 500 earnings multiple is only 16.94. This makes some view the Shiller PE ratio to be an obsolete metric since it looks at past results. The Shiller PE is at 34.67. That puts it in the 97th percentile using the past 120 years of data and the 83rd percentile in the past 20 years. The reason I think CAPE is still valuable is because I believe every factor that is pushing earnings up in 2018 and 2019 is cyclical, the tax cut included. Why should I pay up for stocks based on the recent tax cut if I don’t think this rate will last in the long term? It depends on your time frame. If you’re investing for the next 12 months, you will pay up for stocks, but if you’re investing for the next 10 years, you shouldn’t pay these high valuations.
It Has Been A Great Start To The Year
As I mentioned earlier, this has been one of the best starts to a year ever. As you can see from the table below, the 7% returns in the first 18 days of the year makes this the 5th best start to a year since 1928. Looking at these years doesn’t make me that optimistic because the median return for the rest of the year after day 18 is 8% and the average return is 1%. This shows that some of the data points imply the momentum doesn’t always continue. The maximum drawdown is on average 20%. That sounds like a lot to investors in this current market because they’re used to corrections not exceeding 5%. That drawdown is higher than the average intra year drawdown which is about 13.5%.
There’s also data on mid-term election years which I think is valuable because fiscal policy has meant so much to this market in the past few months. As you can see in the table below, the average intra year pull back is the biggest in mid-term election years which were are currently in. That means the political cycle and the returns to start the year both imply a big pullback will occur this year. One potential baseline case I’ve been toying with is the concept that the stock market will have a sharp correction this year of about 10%-15% and then rebound in the next 1-3 years before the economy reaches a recession. Stocks might not ever reach this year’s peak before the recession. The reason why I’m considering this is because the stock market is very overbought, but a recession isn’t likely until 2020.
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