Will Earnings Growth Come in for a Landing?
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After three years of positive and accelerating growth, earnings growth is expected to slow starting after the current quarter (figures 1-2). 2015-16 growth was held back by the “recession” in the commodity and industrial markets. 2017 charged back as oil prices and the economy recovered, and 2018 is benefiting from lower taxes. However, these good times are expected to fade as comps become much more difficult in 2019, and 2019 growth is expected to slow.
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Even though a large majority (78.9% through 7/30/18) of companies are beating 2Q estimates, overall surprises are much subdued from recent quarters and are only ahead by 2.5% (figure 3), with the past year market leader (information technology) getting clobbered.
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2019 expected growth is broad-based (figure 5). Still, it is led by energy and other cyclical sectors including consumer discretionary, industrials, technology, and financials. As noted in Tactical Asset Allocation Over the Cycle, cyclicals have been leading the markets; however, since June, defensives (consumer staples, health care,
telecommunications, and utilities) have outperformed. Perhaps the market has already priced in current and expected solid growth, or it is questioning 2019 numbers?
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It is more difficult to grow quickly after a year of great growth (2018) as comps get tough. Plus, in 2019, margins are expected to continue expanding from already historically high levels (figure 6). As note in Thinking About Technology, margins have risen over time because of 1) lower taxes, 2) productivity growth surpassing wage gains, and 3) lower interest rates. In 2019, the market will not have a stepped-up benefit from additional tax relief, wages are likely to pick up due to the tight labor market (partly offset by rising productivity), and interest rates may rise. Furthermore, a stronger dollar, if recent gains are sustained, could eat into earnings (figure 7). Finally, trade has the potential to hit companies’ top-line revenue and add to costs. Besides the obvious impact of lower sales due to retaliatory tariffs against the US and higher costs of materials, countries may also battle us with other retaliatory practices. Consider, for instance, that Apple generates about a fifth of its sales from China, and China can harass the company and influence its growth (see “Apple Comes Under Media Fire in China,” WSJ, July 31, 2018).
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Driven by tax reforms, EPS revisions have been positive throughout 2018 (figure 8) and this has helped drive up returns (figure 9); however, revision breadth appears to be peaking (figure 10) (June was only 0.05). Can things get much better? If markets are efficient – and I am definitely not saying they are – then returns should react in the same direction as revisions.
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A Slow Smooth Landing is Not Necessarily Bad for the Market
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Slowing growth sounds bad, but it does not necessarily mean that the market returns are negative.
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Since 1873, 61% of the annual periods (using monthly data, or 1061 of 1743 total periods) experienced positive growth (second column of figure 11), and 52% of the time growth was slowing (fifth column of figure 11). Of these 1061 periods of positive growth, 360 experienced slowing growth (defined as the current year’s growth rate versus the prior year’s growth rate). Furthermore, growth is positive 40% of the time that growth is decelerating. Thus, the period we are about to enter (expected positive but slowing growth) is not unusual.
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Markets are up about two-thirds of the time (63% since 1873 and 72% since 2000) (second column of figure 12). 35% of the positive return periods since 2000 (21% since 1873) were when growth was positive but slowing. Even when growth has been negative, sometimes returns were positive (e.g., if market participants expect a rebound). 15% of positive markets since 2000 (29% since 1873) were during periods of negative growth. Importantly, when growth is positive and slowing, the odds of positive returns do not decrease versus the overall average. Since 2000, in this environment, 56 of 58 times returns were positive. Since 1873, 232 of 350 periods were positive. Thus, positive but slowing growth is not necessarily a harbinger of negative returns.
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Do Not Forget About Valuation
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While growth drives markets, valuation may matter even more. Returns are a function of the price one pays for earnings (P/E) times earnings (E) (i.e., P/E * E = P). The vast majority of investors’ focus and forecasts appears to be on “E,” but changes in P/E is even more important. The R-squared of annual returns of the S&P 500 to changes in next 12-month P/E is 69%, whereas the R-squared to NTM EPS growth is only 42% (figures 13-14).
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The S&P 500 P/E is elevated. The trailing 12-month P/E (TTM P/E) is 23.41 (March 2018) and the 5-year average is 21.47 (figure 15). The Shiller P/E was only higher during the 1990s tech bubble (figure 18). While low inflation and interest rates justify higher valuations (figures 16 and 19) as long as EPS does not falter, higher valuation is normally associated with lower future returns (figures 17, 18, and 20).
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Not surprisingly, P/E was above or below average about ½ of the months since 2000 and 1873 (columns 2 and 3 of figure 21). If returns are negative, this occurs more often when P/E is above average; however, above average P/E is still more common with positive than negative returns. Plus, it is slightly more common (since 2000, 1990, 1980, and 1970) for P/E to be above average ahead of positive growth (columns 8-9 of figure 21). P/E likely rises in anticipation of higher growth, or because the market looks through a temporary dip in EPS.
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Wrapping Up
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We are entering an unusual regime of above average P/E and positive but decelerating growth (figure 22). Depending on the time period, a low P/E is three times to ten times as likely as an above average P/E when positive growth slows (columns 5 and 9 of figure 22). This may be because slowing but positive growth is a precursor to negative growth; thus, earnings are at risk and investors are less willing to pay up for them. However, today it appears investors are ignoring this danger.
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While this may raise the alarm, since 1970, 1990, and 2000, returns have still been positive more often than negative during this high P/E and positive but slowing growth regime (columns 6 and 14 of figure 23). Although, there are only a few of these periods (12 periods since 1970) so the results may be influenced by outliers. Going back to 1873, there were still only 81 instances when positive growth slowed during an above average P/E period, and returns were positive during slightly less than half of these periods. This is lower than the hit rate (64%) for positive returns over the entire series. Thus, while this situation is not terrible for returns, it is also not good. Positive returns are most commonly associated with positive and accelerating growth with above-average P/E (the period of 2017-18), followed by positive and accelerating growth with below-average P/E or positive and decelerating growth with below-average P/E depending on the time period.
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