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Third Quarter Earnings Could Turn Blue Skies To Grey

Summary

We believe strong forecasted third quarter earnings growth is likely priced-in.  Companies will need to "beat and raise" to maintain or increase their share price.

Not expecting much margin expansion from current levels of ~16.6x 2019 estimates, earnings acceleration will likely drive prices higher over coming months.

Still believe historical trends relating to mid-term election year performance will play out over the coming months.

Beginning next week third quarter earnings reports for many public companies will be in full swing. We have compiled estimates from three sources, FactSet(1), ThomsonReuters(2), and Yardeni Research(2), which on average, suggest current third quarter 2018 earnings per share estimates imply year-over-year growth of ~21% for S&P 500 Index companies. This would equal an almost 5 percent decline from reported earnings growth of 25.8% during the second quarter, albeit year-over-year growth is accelerating compared to the second quarter. According to FactSet, negative pre-announcements for third quarter equaled 74, or 76% of total pre-announcements, but only slightly higher than the 5-year average of ~71%. Consumer Discretionary and Healthcare, were the two highest sectors of negative pre-announcements for the third quarter. FactSet was also noted that since June 30th, only two sectors, technology and financials have seen estimates increase during the third quarter.

Given the recent move higher for the S&P 500 index, we believe investors have largely already baked-in estimated third quarter earnings growth, and perhaps even some outperformance. In our opinion, this will likely require companies to beat and raise fourth quarter estimates to maintain or further increase current share price over the near-term. The current average estimate for fourth quarter S&P 500 earnings suggests year-over-year growth of ~17%, down another 4% sequentially from current third quarter estimates. On average, according to FactSet data, the typical revision in earnings estimates for the S&P 500 during the quarter is a little more than ~3% lower. Thus, we could see fourth quarter estimates move closer to ~14-15% following third quarter earnings based on current historical average. This would still imply year-over-year growth for 2018 S&P 500 earnings of ~19-20% versus the current estimate of ~22%.

We anticipate significant commentary from companies regarding a potential softer fourth quarter outlook due to negative impact from global tariffs. This could likely cause some stocks to see pullbacks as investors may choose to reset valuations due to potential tariff headwinds. We believe a consensus is building across Wall Street that current trade conflict between China and the United States could become reality, and the duration may be longer than some had previously estimated. Other headwinds we see for fourth quarter guidance include 1) strong dollar, negatively impacting S&P 500 companies due to ~38% international revenue exposure and 2) rising interest rates, causing investor concerns regarding amount of debt on corporate balance sheets and increasing levels of interest payment coverage.

Entering the fourth quarter, most investors will likely have transitioned towards 2019 earnings estimates as the basis for current stock price valuation. Given the positive impact of tax reform in 2018 earnings, current estimates for 2019 suggest a much more subdued growth outlook. The current average 2019 S&P 500 earnings estimate equals ~9%, down greater than 50% from current 2018 estimates. According to FactSet, the Energy sector will offer the highest earnings growth within the S&P 500 for 2019, the same as 2018. Outside of Energy, Consumer Discretionary, Industrial, and Communication Services are the only other sectors currently estimated to grow earnings greater than 10% in 2019.

We believe price-to-earning (P/E) multiples have expanded during the third quarter, now equaling, per our average, ~16.6x 2019 estimates. In comparison the 5-year average is ~16.3x, and the 10-year average is ~14.5x. We believe further S&P 500 index gains will be driven by increasing earnings estimates and likely see limited expansion of multiples from current levels. A key factor in our thesis regarding flat to down forward multiples for S&P 500 earnings is due to increasing interest rate levels, which have historically negatively impacted stock valuation multiples. On an individual basis, per FactSet data, Consumer Discretionary companies are trading at an average forward P/E of ~22.4x, versus the 5-year average of ~18.5x. Financials are currently trading at ~12.4x 2019 estimates compared to a 5-year average ~13.1x. Even with strong estimated growth in both 2018/2019, the Energy sector is trading at only ~17x compared with a 5-year average ~28.4x.

If the current S&P 500 earnings multiple was to move towards the average of 5-year/10-year ranges, it would suggest levels of ~15.5x. Based on ThomsonReuters estimates for 2019 S&P 500 earnings of $178.50, that would suggest an index value of roughly 2,767 compared to recent levels above 2,900. We believe a revision towards levels ~16x is the more likely outcome over the next 6-9 months. Many outlooks from leading bank strategists suggest the S&P 500 will exceed 3,000 over the next 6-9 months. In order for the index to reach levels of 3,000, we believe the forward earnings multiple would need to be ~16x, with ~5% higher earnings estimates compared with current 2019 consensus. If we assume the same ~16x multiple, we believe 2019 estimates would need to increase ~23% to achieve levels of 3,500. Based on a level of 2,950 exiting 2018, an arbitrary figure, an increase to 3,000 would imply potential stock market price appreciation of ~2% in 2019. Assuming a move towards 3,500, it would imply potential price appreciation of ~19%. The average of these two estimates suggests 2019 could still offer potential double-digit price appreciation in the S&P 500 index.

Given the recent significant move in the U.S. 10-year Treasury yield, climbing above 3.2% in trading on October 4th, to equal the highest level in 7 years, we believe investor concerns regarding an inversion of the yield curve will likely shift towards concerns regarding higher long-term interest rates and the potential negative impact on future S&P 500 earnings growth. Historically, the inversion of the U.S. Treasury yield curve, which means 2-year yields exceed 10-year yields, has been a reliable indicator that a recession is nearing. With the spread on the 2/10-year Treasury beginning to expand, we believe investors will suggest that potential lower equity valuations in the near-term are due to investors’ concerns regarding higher rates and future growth prospects. While it is evident that earnings growth is slowing given current 2019 estimates, we believe current 2019 earnings forecasts could prove conservative and based on historical trends interest rates remain relatively low.

We still believe historical trends relating to mid-term election year performance will play out over the coming months and into early 2019 but expect to see volatility in October due to stock price fluctuations around earnings reports.

Sources:

1 - Butters, John, “Earnings Insight” FactSet, September 28, 2018, https://www.factset.com/hubfs/Resources%20Section/Research%20Desk/Earnings%20Insight/EarningsInsight_092818B.pdf

2 – Yardeni, Edward Dr., Abbott, Joe, “YRI S&P 500 Earnings Forecast” Yardeni Research, Inc., October 1, 2018, https://www.yardeni.com/pub/yriearningsforecast.pdf

3 - Yardeni, Edward Dr., Abbott, Joe, “Stock Market Briefing: S&P 500/400/600 Weekly Fundamentals” Yardeni Research, October 4, 2018, https://www.yardeni.com/pub/peacockfeval.pdf