Market Commentary

Q3 Earnings Season—Don’t Get Spooked

analytics-925379_1920_9It’s that time of the year again where we can see a snapshot of the health of the economy through the corporate lens. That’s right: It’s earnings season! Over the next several weeks, companies will report their preceding three-month results through SEC filings and, usually, a conference call to discuss results with investors and analysts. These quarterly events are typically paramount for market participants to get a clear idea of business trends that help determine where a stock – and the market – could potentially go.

We anticipate this quarter will deliver strong prospects to warrant further long-term market appreciation but, admittedly, there will be much more “noise” and volatility as headline earnings growth rates won’t look quite as robust as prior periods. Nevertheless, when the onion is peeled back, we think core earnings remain strong and, more importantly, companies’ outlooks for the year-end quarter will add support to the market, keeping us bullish.

Part of the reason for the upward momentum in the equity markets over the last several years has been a result of consistent, rapid earnings growth. For example, in the first quarter of 2009 when the market bottomed during the financial crisis, the forward 12-month earnings per share (EPS) estimate for the S&P 500 was less than $50, compared to today where it’s over $140. That near-tripling in under a decade has been the result of cost cutting and sales growth. Companies have streamlined operations by improving materials sourcing, finding cheaper input costs, innovating and consolidating through mergers & acquisitions. Companies have also used low interest rates to finance expansion into new markets and business segments. This combination has created larger revenue bases and allowed for those revenues to flow more purely to a company’s bottom line.

However, that trend could be disrupted this quarter as two major hurricanes stalled the economy and caused billions of dollars in damage. This disruption will likely be exaggerated by a typical seasonal slowdown that happens during the summer. Waning year-over-year strength from the energy sector could also slow things down. Before the hurricanes, Wall Street expected S&P 500 earnings growth to be 7.5% for the third quarter. In wake of the destruction, analysts revised estimates down to 2.8%.  That is a material slowdown from the second quarter where the S&P 500 delivered double-digit earnings growth. That said, we’d note that over the last five years, reported earnings have come in, on average, 4.2% above consensus expectations. If history is consistent, this would put the actual third quarter earnings growth rate around 7%, a much more respectable level given the circumstances.

Earning-seasonRegardless of where the actual growth rate shakes-out, we believe the underlying fundamentals continue to improve. This is supported by expanding margins during a comparatively unimpressive growth quarter. The net margin (the amount of income a company earns on each dollar of revenue after taxes are stripped out) for S&P 500 companies is expected to widen to 9.49% in the third quarter, yet another record. That level of corporate profitability is up almost a full percentage point relative to last quarter and the same period of 2016, with only some of the improvement the result of a weak US dollar. To us, this is clear evidence the growth outlook will be much more robust going forward and the “lull” is just temporary due primarily to unforeseeable factors.

This quarterly earnings season is a friendly reminder that earnings are backward-looking, while stocks are forward-looking. This means the market is likely to eventually brush off meager earnings growth in the face of accelerating outlooks. Currently, Wall Street analysts expect 11.1% year-over-year earnings growth in the fourth quarter, a rebound that we think is likely to continue well into 2018. While there are always upside and downside macroeconomic risks, these earnings forecasts keep us bullish on the fundamentals of our portfolio and on the markets.