Earnings season officially kicks off this week, so let’s begin with a quick look at how expectations have evolved, and what it could mean for stock prices moving forward.
The first thing to note is that S&P 500 earnings are expected to decline for the first time since Q2 of 2016. While the decline should be modest (-4.2%), what’s interesting is how earnings expectations and stock prices have diverged during the 1st quarter.
Back on December 31st, shortly after the market had bottomed, the estimated earnings growth for Q1 stood at a positive 2.8%. Fast forward three months, and all eleven sectors of the market have lower expected earnings growth rates.
And yet, while numerous downward earnings revisions have piled up, the market has gone nowhere but up. So we have stock prices up, while expected earnings growth has collapsed – what gives?
As much as I hate to say it, I believe this divergence is a reflection of how much control the Federal Reserve still maintains over the psychology of investors. The about-face that we witnessed in recent months seems to have created a strong risk appetite, as investors believe the Fed “put” is squarely back in place.
Part of the reason I think much of this is Fed and investor psychology related is because if I stop and think about what’s improved since the end of the year, the list isn’t all that long. We haven’t seen a marked turnaround with respect to underlying fundamentals or the global landscape. One could argue that we may be closer to trade deal with China, but with the recently proposed $11 billion in tariffs on European goods, the trade saga could be far from over.
Another factor that may be partly responsible for this divergence is the move in bond yields. The yield on the 10-year note is shown below, and remains in a sustained downtrend. As yields head down and remain suppressed, it pushes us back toward the TINA (There Is No Alternative) environment that persisted a few years ago.
Bond yields may not be as low as they were back in 2012 or 2016, but the current 2.5% yield on most maturity Treasuries provides little in the way of real return. Those who aren’t content with a sub 1% real return must go elsewhere with their money.
This view is further supported by the fact that junk bond prices remain at multi-year highs. The search for yield remains very real …
One final factor that highlights this dynamic involves a comparison between bond yields and earnings yields. Recall that the earnings yield is the inverse of the P/E ratio, and shows what a $1 investment in stocks yields in terms of earnings.
Right now, the trailing 12-month P/E ratio for the S&P 500 sits at about 21.5. That works out to an earnings yield of about 4.65%. Compared to the 2.5% yield that Treasuries currently provide, the valuation of stocks can be considered quite reasonable. (Recall that investors in stocks should receive some type of “risk premium” as compensation for the additional risk assumed with stocks as opposed to bonds. Right now that risk premium is a little over 2%.)
So perhaps it’s the Fed, or low bond yields, or a combination of both, but right now equity investors seem comfortable with the general outlook. It’s as if they’re saying “who cares if we have a minor earnings slowdown, the Fed will be there to support growth and there’s really no other place to put my money anyway.”
Moving on, over the past week there hasn’t been much in the way of anomalies with respect to economic data. Durable goods orders declined slightly in February, but nothing serious. Motor vehicle sales came in better than expected, while job growth remained strong in March, coming in at 196k. The unemployment rate remained at 3.8% while average hourly earnings rose a bit less than expected, and jobless claims remained low.
With regard to the jobs report, there is one interesting development worth highlighting and it’s the slowdown in wage growth. In the chart below, courtesy of Charles Schwab, we can see average hourly earnings growth in blue and the unemployment rate in yellow.
As you can see, during economic expansions these two rates typically converge. However, near the end of the economic cycle, they’ll diverge as wage growth slows and unemployment begins to rise. With the latest jobs report, these two metrics did in fact begin to separate. I don’t think this warrants any immediate concern, as there is volatility in the data, but it’s one more indication that we are in the late stages of this economic cycle.
Overall, I think the message continues to remain the same: In the near-term the U.S. economy remains on firm footing, but we do have a tough global landscape and could find ourselves in a tricky environment later in the year.
As we wrap things up, there’s one last item I thought you might find interesting. In the chart below we can see how the vast majority of the 2018 tax cuts went to buybacks (red line) as opposed to Capex (blue bars). I don’t think anyone expected anything different, but nevertheless that’s what happened.
These buybacks helped to financially engineer higher EPS growth, which makes 2019’s year-over-year comparisons all the more difficult. As earnings season kicks off on Friday, we’ll see how this year’s results begin to stack up.