Q1 2019 EPS Growth - The Cyclicals Are Cheap Relative To The S&P 500
The chart below is shocking because the forward PE of cyclicals versus the forward PE of the S&P 500 is much lower than it has been since 1980. There are a few takeaways from this metric.
The most obvious one is cheap cyclicals mean investors are anticipating a terrible economy. Panic in late 2018 probably went too far. At a certain point, even if a recession occurs, stocks can still be a buy.
You can’t just focus on the timing of the potential recession without looking at valuations.
Another key point is cyclicals are a buy when they are expensive and a sell when they are cheap because the PE multiple is low at peak earnings and high at trough earnings.
To be clear, forward estimates are heightened at the top of the cycle and suppressed during recessions. However, those forward estimates are incorrect. They only represent analysts’ sentiment.
The final key point is the forward S&P 500 multiple contracted sharply in 2018 because earnings growth was so strong. Cyclicals being cheaper than the S&P 500 makes them very cheap.
Everyone has an opinion on forward earnings projections. They have come down sharply which reflects the negative macroeconomic sentiment and some of the weak earnings reports from Q4.
This is either a low bar which is easy to surpass, or an indication of a weakening economy. It might be both. The economy may be slowing, but estimates might still be beat.
Q1 2019 EPS Growth - Estimates Have Fallen Sharply
The rate of change of earnings estimates gives us a good idea where stocks are going in the near term. Because of the recent volatility in stocks, it’s no surprise estimates for the next few quarters are falling.
Q4 2018 will still have double digit earnings growth since estimates will likely be beat. However, the key point this earnings season will be guidance as it always is.
As of January 7th, 67% of the 18 firms that reported earnings had their Q1 estimates cut. The average decline is 5.29% which is terrible. Last quarter, 59% of firms had their estimates cut with a decline of only 0.35%.
Q1 2019 EPS Growth - It’s still early in the quarter, but the results aren’t promising.
As you can see from the table below, Q1 2019 EPS growth expectations declined from 7.94% on November 1st to 5.02% on January 8th.
This is terrible in rate of change terms. However, if earnings growth ends up being positive, the 20% decline in the S&P 500 at the trough of this recent bear run isn’t justified.
Earnings need to fall to justify bear markets in the intermediate term because PE multiples will shrink if earnings grow and stocks fall. Obviously, stocks can move in any direction in the short run, but those are buying opportunities if the fundamentals don’t justify the weakness.
The other possibility is stocks fall on slightly positive growth because they expect declines in 2020.
Q1 2019 EPS Growth - ISM Non-Manufacturing Index Falls
Soft economic data has been missing expectations and showing us growth is slowing. However, it’s fair to say the decline in stocks still probably wasn’t justified. The December non-manufacturing ISM PMI report is a great example of this situation.
As you can see from the chart below, the PMI fell from 60.7 to 57.6. However, this is only slight below the 12 month average which is 58.9. The economy is still expanding, and services is outperforming manufacturing. Services is much more important to the economy than manufacturing.
The bad news is the PMI missed estimates for 58.4. The good news is this PMI is consistent with 3.2% GDP growth. This is near the CNBC median estimate which is 2.9%. My opinion on stocks for the past few weeks has been that the data justifies a correction, but not a bear market.
None of the metrics have been falling off a cliff. The government shutdown is delaying some of the data releases. But this decline occurred when the government was still open.
Let’s now review the specifics of this report. Business activity index fell 5.3 points to 59.9. New orders index was up 0.2 to 62.7. Decline in commodities prices caused the prices index to fall 6.7 points to 57.6. Employment index was down 2.1 points to 56.3, starkly differing from the BLS report.
Q1 2019 EPS Growth - ISM Quotes
Quotes from this report don’t justify the decline in stocks. I’ve seen perma-bulls arguing that the decline in the ISM PMI is sentiment driven.
In other words, they believe the negativity caused a low PMI even though business isn’t terrible. The quotes aren’t consistent with that point as most firms are still positive.
A retail trade firm stated, “Business is very good. Strong demand and pipeline.” Retail sales were strong this holiday season because of the strong labor market.
A firm that manages companies and provides support services stated, “Overall, our year-end outlook is positive. We are already receiving converted RFPs to orders for 2019. Based on the uncertainty of the tariffs, we have advised our clients to make purchases early in first quarter 2019, if possible, to save money. There is concern in our industry regarding the full year due to tariffs, unless a deal can be reconciled with China. We expect lower profit margins and reduced sales for 2019 until our suppliers can source product from other countries, which may not be until late [in the year].”
Tariffs are a negative, but it seems like a deal is being worked on if you believe President Trump’s tweets.
Q1 2019 EPS Growth - Conclusion
A key point to realize is rate of change weakness means there is an economic slowdown, not a recession.
The decline in December started to price in a recession. As I mentioned, the cyclicals have become extremely cheap relative to the overall market. The good news is 2019 earnings growth is still expected to be positive.
December ISM PMI implies 3.2% Q4 GDP growth, and the median of 10 estimates expects 2.9% growth. There needs to be a sharp turn in the data akin to what we’re seeing in Germany and China to justify the trough stock market valuations. If that doesn’t happen, stocks will rise in 2019.
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