Earnings Season Is Ready To Save The Stock Market

Earnings Season Saved The Market

Earnings season will be starting this month. That’s a welcome relief for the stock market which has been dealing with a lot of negative headlines mostly from the tariff battle with China. The market is in an unusual situation where earnings growth is remarkably strong even though the business cycle is close to ending. Cyclically, regulations tend to be relaxed at the end of the cycle, but the timing of the tax cuts and repatriation holiday is unique. Adding in that this is already the second longest recovery since 1854, makes this a period which is incomparable to others.

One other factor is that this market had been surviving on momentum from the election in November 2016 until January 2018. The optimism peaked and stocks corrected. Usually when a stock goes through a period where it shifts from being owned by growth investors to value investors, it goes through a major crash which takes many months to recover from. The market didn’t need to do this because of how quickly earnings will be growing in 2018. It’s tough to underestimate the size of the decline that would’ve occurred without the tax cut. It could’ve easily been 20% to 30%.

Great Guidance

The 2018 earnings aren’t just pie in the sky expectations even though they seem like that. The estimate revisions were the best ever and the 53 firms reporting positive EPS guidance is the highest since at least Q2 2006 when FactSet began calculating it. The chart below shows the sector level breakdown of the positive EPS guidance for Q1 compared to the 5 year average. Since this is the best quarter in the past 12 years, most sectors are higher than the average. As you can see, the tech sector is leading the pack with 26 firms reporting positive guidance. This is interesting because tech has been selling off in the past few weeks.

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Social Media Business

In my opinion, the best way for the tech sector to rally is for the firms which aren’t facing regulatory scrutiny to become the new leaders while the ones facing the issues struggle. Microsoft faced antitrust issues in its growth heyday. Let’s see how Facebook deals with its woes. Mark Zuckerberg will testify in front of Congress on Wednesday which is always a bad sign. Mark has stated Facebook will be investing so much in safety and security that it will impact profitability. That’s not a good sign, but it’s the best option in a situation with a bunch of bad ones.

The social media business model is changing for the worse. It used to be that social firms would pay to host the content and charge advertising fees. It is a great business model to have free content and charge ads to view it. Unfortunately, social firms need to pay humans to monitor the content instead of using free bots because the bot failures end up causing huge PR blunders. A robot can’t detect the nuance of a statement to determine if it is offensive. Just deleting certain words is not enough to police the platforms. At best, costs will go up. At worst, users will post less because they disagree with the restrictions.

This slew of regulations will hurt Facebook the most and should impact Alphabet and Twitter as well. Like I said, the tech firms who aren’t involved in this controversy need to become the new leaders of the market.

Breakdown Of The Tech Sector Pre-Announcements

As you can see from the chart below, the positive EPS guidance in the tech sector is dramatically higher than the previous earnings peak in 2014. The 5 year average is 11 firms announcing positive EPS and this quarter has 26 so far. There are plenty of firms not facing stiffer regulations which can power the tech sector higher. 8 of these firms issuing positive guidance are software firms and 7 firms are in the semiconductor and semiconductor equipment industry. The good news is that the tax cut isn’t the only thing driving earnings as 28 firms in the tech sector have issued positive revenue guidance which is higher than the 5 year average of 17.

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Industry Analysts Are Very Optimistic

The chart below shows the bottom up price target of the S&P 500. The target is near where the market is right now, but by the end of the year and early 2019, the estimate increases quickly. The analysis predicts the S&P 500 will go up 16.2% in the next 12 months. It’s important to recognize that these price targets are bottom up, making them better than the top down ones you often see in the financial media. Many investment banks change their price targets with the whims of the market which makes them useless. Firms raised their price target after the January rally. That looks like a mistake now because the market still hasn’t matched the all-time high seen in January. The bottom up analysis doesn’t change with the market because it’s based on median analyst estimates for each firm.

Specifically, the tech sector is expected to go up 18.2% in the next year. That’s what happens when a sector declines while analysts expect better earnings growth. The energy sector is expected to go up 18%. Utilities are expected to go up the least as the projection is for a 4.8% improvement. In the past 5 years, these price targets have been underestimating price by 0.2% which is amazing accuracy. This high level of accuracy has occurred because the market has been following the changes in earnings. Recessions, which aren’t predicted by analysts, have sharp drawdowns in earnings which causes analysts to overestimate earnings and subsequently stock prices. Analysts are usually too pessimistic coming out of a recession as they are following the trends. Luckily, the economy is cyclical; it doesn’t fall into a spiral when GDP declines indefinitely.

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Conclusion

Earnings are going to be unusually great which might act as a catalyst for stocks to move up in the next few weeks. While uncertainty can cause a correction, the market can’t fall into a bear market unless bad news is expected to start directly affecting earnings. For now, most of the fears are still in the heads of investors which means this might be a buying opportunity.