(Bloomberg) -- Stock investors have stopped heeding the increasingly skeptical message of Wall Street earnings forecasters. Maybe everyone should.
Pessimism of any type is starting to look like a misjudgment in the stock market of 2019, a year with a shot at becoming one of the best in decades. The S&P 500 has surged for four straight weeks, closing at a record three of the last five days. All as company analysts keep slashing 2020 estimates.
It’s a weird divergence: stocks up, earnings estimates down. Don’t corporate profits call the market’s tune? The issue is whose expectations you believe. While a reduction in analyst projections is to some degree natural at this time of year, forecasts from corporate America have quietly started to improve. And the latter is the trend it has paid to follow.
“We’ve gone from earnings being too high and needing to come down to earnings probably being too low and needing to come up,” said Mark Hackett, chief of investment research at Nationwide Funds Group, which oversees $65 billion. “The tone of management teams in their quarterly communications are much more positive.”
For anyone afraid of a repeat of last year, when plummeting earnings projections by analysts preceded a market meltdown, the last few weeks have been a relief. With the S&P 500 up 22% in 2019, skepticism over the advance runs deep. Especially if you believe next year’s earnings estimates are too high. But a dose of confidence from company management is soothing bulls.
Corporate guidance has grown steadily more optimistic since the summer, Bloomberg data show. The share of companies that have issued outlooks higher than consensus estimates over the last 12 weeks now stands near 45%, the highest since January.
According to BMO Capital Markets, stocks almost always go up in periods following bottoms in corporate guidance. Twelve months after a trough, the S&P 500 gained 14% on average, according to strategists led by Brian Belski. As it stands, the benchmark is up 5% from the turn in guidance seven months ago.
“Companies are not panicking yet, which leads us to believe any potential EPS estimate drawdown will not be as severe as feared,” the strategists wrote. “In fact, guidance levels have been steadily improving since early summer, despite the perception that CFOs are only signaling bad news.”
Positive guidance hasn’t kept analysts from taking a knife to their own profit estimates. Since the end of August, earnings-per-share forecasts for companies in the S&P 500 have fallen from $181 to $177.70, a decline of about 2%, Bloomberg Intelligence data show. That’s more than three times the degradation seen last year over the same period.
But even after all those downgrades, analysts still expect profits to increase 9.3% next year, though that predicted rate is likely to shrink further. Jonathan Golub, Credit Suisse’s chief U.S. equity strategist, has estimated the historical trend alone would result in a drop to 5%.
Nationwide’s Hackett envisions an environment in which profit growth ends up exceeding that. A weaker dollar and less margin compression could help reported earnings for 2020 grow 8%, he says. For investors assuming the historic drift will prevail, that would come as a positive surprise.
Where to take your cues from, then? One kink in the argument for turning exceedingly optimistic is that while guidance is rising, it’s doing so among a smaller contingent of firms. More than usual are saying nothing about the future. “Expectations for 2020 remain sparse,” writes Bloomberg Intelligence’s Peter Chung.
“The problem is that at the moment everyone is in a wait-and-see because the trade war is so important for all the companies,” said Didier Anthamatten, senior portfolio manager at Unigestion SA, which oversees $23 billion. “If you don’t know what’s going to happen with global trade, it’s tough to give guidance.”
Consider the following commentary from select companies’ earnings calls this season, captured by Bloomberg software, acknowledging trade and macroeconomic uncertainty:
“For now we are focused on closing out the year and planning for 2020. The environment is highly unpredictable given how much of it is at the mercy of political machinations, whether it’s trade negotiations or even the elusive resolution on Brexit,” said Michael Corbat, CEO.
Estee Lauder Companies Inc:
“We recognize that a variety of macro risks such as ongoing trade tensions, Brexit and continued challenges in Hong Kong’s retail environment could impact our fiscal 2020 results,” said Tracey Travis, chief financial officer.
Hilton Worldwide Holdings Inc:
“Everybody is reading the papers, watching what’s going on with Brexit, watching what’s going on with the trade wars, not only in the U.S. and China, but Korea and Japan; looking at broader economic issues, and election year coming up in the U.S. and impeachment process going on,” said Christopher Nassetta, president and CEO. “That’s what you’re seeing in the results is the caution flags are out, people are doing fewer things.”
Wall Street’s record of success in predicting corporate earnings doesn’t inspire confidence to begin with, though generally they err in the direction of optimism. From 2007 to 2017, the actual pace of S&P 500 per-share earnings growth was on average 7.4% lower than what analysts had expected at the end of the previous year, data compiled by Bloomberg show.
According to research by Bloomberg columnist Nir Kaissar, analyst forecasts are so unreliable that investors are better off ignoring them, and simply assuming earnings in any given year will be the same as the previous one.
If that’s the case, it’s no major reason to cheer. Companies in the S&P 500 are on track to grow profits by 1.5% this year, the slowest rate since a contraction in 2016. But that still represents an increase from last year’s earnings that were aided by corporate tax cuts.
For the time being, hints on the trajectory for the U.S. economy and trade negotiations are key. The S&P 500 rose 1.5% in the past five days to close higher for a fourth straight week after a strong employment report and signals that the U.S. and China are making progress in their discussions.
“If trade improves, the positive earnings growth will continue and probably accelerate slightly,” said Alec Young, managing director of global markets research at FTSE Russell. “If trade doesn’t improve and takes a turn for the worse, it could wipe out the earnings growth. It’s a very binary and uncertain environment.”
--With assistance from Claire Ballentine and Olivia Rockeman.
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