by David Aurelio.
The year that was supposed to see record profits fueled by a strong economy and further enhanced by tax cuts has been anything but predictable. Instead, the S&P 500 is on track to post its most volatile year since 2008 with valuations similar to Dec. 2007. As 2018 comes to a close, investors are hoping that 2019’s earnings estimates don’t drop like the Times Square Ball.
Exhibit 1: S&P 500 YoY Earnings Growth Rates
The S&P 500 is expected to see 2018 revenue increase by 8.7% and earnings to increase 23.8%. This is the highest earnings growth rate since 2010’s 31.0%. Quarterly earnings for 2018 have beat estimates at a rate of 78.6%, which is on track to be the highest on record (through 1994). Some are quick to dismiss the earnings performance and over attribute it to tax reform, which is expected to see the index’s effective tax rate decline to 20% from 26%; however, even if the tax benefits were backed out, earnings growth would be 14.3%, which would still be the highest since 2010. In other words, strong fundamental growth has been amplified by tax reform.
Exhibit 2: S&P 500 Earnings Yield, U.S. Treasury Yields, Inflation, and GDP
The 18Q4 earnings season kicks off during the second week of January. Earnings are expected to be strong and 94% of the companies that have reported, beat estimates. However, with the S&P 500’s current forward 12 month (F12M) P/E at 14.4, the focus of this earnings season will be on 2019 guidance. This is because some see the 14.4 P/E as attractive relative to the 30 year moving average of 15.1, while others see it as a warning that downward revisions to estimates are on the horizon. Given that the index has seen the most volatility since 2008 it doesn’t help that the S&P 500’s 12 month forward P/E was also 14.4 on Dec. 27, 2007.
The reciprocal of the F12M P/E is the F12M earnings yield (E/P). While the F12M E/P of 6.9% is similar to Dec. 27, 2007, the U.S. rate environment is not. On Dec. 27, 2007, both the U.S. 10Y and 2Y yields were in a decline and the spread between earnings yield and the U.S. 10Y was 7.7 percentage points. In contrast, today the Fed tightening has rates on the rise and the earnings to U.S. 10Y spread is 4.2 percentage points.
The double edged sword of a stronger economy is that it is often associated with rising input costs such as: labor, material, interest, etc. Margin compression due to rising costs can often be offset by price increases, improved efficiency, cost reductions, and/or debt reduction. However, not all companies have the ability to fully mitigate. Therefore, it is surprising to see that analysts expect the S&P 500’s gross margin to expand and pre-tax profit margin to remain relatively stable in 2019 even though 2019’s revenue growth of 5.6% is expected to slow relative to 2018’s 8.7%.
These margins are especially surprising when considering that many of the tariffs don’t kick in until 2019, more rate hikes and further QT are anticipated for 2019, and global economic growth is expected to slow.
Exhibit 4: Changes to S&P 500 Bottom-Up EPS Estimates from Jan. 1 of the Prior Year
Bottom-up EPS revisions data shows that analysts are slow to make revisions to annual estimates. This can be seen in the delayed upward revisions to 2018 and 2019 EPS estimates following tax reform and in the delayed downward revisions to 2007, 2008, and 2009 estimates. For example, analyst estimates for 2008 EPS declined by 0.4% from Jan. 1, 2007 to Dec. 1, 2007. Meaningful downward revisions did not occur until after companies started to report 2007 Q4 earnings. Over the course of that earnings season, 2008 earnings declined by 7.2% to $97.22 per share on Apr. 1, 2008, from $104.76 on Jan. 1, 2007.
Unfortunately, historical evidence that suggests analysts are slow to revise estimates combined with expectations for stable pre-tax profit margins and recent company guidance seems to favor the idea that the market is likely predicting the new year will see downward revisions to 2019 EPS estimates.
Additional index earnings reports on Lipper Alpha Insight:
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