Great Headline Earnings Results. What’s Wrong With The Market?

Amazing Earnings Season

The Q1 earnings season has been a big success when looking at the overall headline numbers. As of 10:30 AM Monday, 273 firms reported earnings. 78% of firms beat EPS estimates while having aggregate growth of +25%. 75% of firms beat their sales estimates with +10% growth. These numbers are all courtesy of The Earnings Scout.

Stocks Aren’t Responding To Great Headline Results

The story of this earnings season is how stocks are range bound despite great earnings results. The only things that can change this are a rally in stocks or a slew of bad results. This story is what makes the chart below interesting. It shows the performance of stocks based on whether they missed, beat, or reported in-line earnings results. It’s no surprise to see that firms that have beat earnings estimates only are up 0.4% which is below the 5 year average of 1.1%. Stocks are doing better than their 5 year average when they report in-line and negative results.

The biggest discussion point is why the underperformance of firms which beat estimates is occurring. One choice is to believe everything that has been affecting stocks in the past few weeks is temporary. The thought process states stocks will eventually go up because of these great results. That’s not an unreasonable opinion because the long term fundamentals don’t always drive short term performance. The theory of anyone who actively invests in the markets for the long term is that asset prices vacillate from their true value in the short run, but eventually re-convene with their true value in the long term.

Another opinion is stocks are reacting to the possibility that earnings growth is near its peak. Some major industrial firms have decelerating organic revenue growth. Total revenue growth is being amplified by M&A activity and forex. The sentiment on stocks has gone from euphoric to slightly negative. Stocks trading at the elevated PE multiples they were at in January justifies vetting these earnings reports to see if there are any inadequacies. The positive side of this analysis is that headline earnings growth is actually expected to accelerate in Q2. There might be some weakness in the global economy and manufacturing, but that’s far from enough to justify a bear market.

The final possibility, which is the most popular in the financial press, is that rising interest rates are weighing on stocks. Rising rates make it tougher to justify buying dividend stocks for their yields. It also increases the cost of issuing debt. It can push profit margins lower. The 2 year yield is at 2.48%. This is the highest yield since the summer of 2008. The yield is increasing because of hawkishness from the Fed. It peaked at 5.27% last cycle. I don’t think the yield is at the top for this cycle, but it is getting close. I don’t think the current expectation for 3 rate hikes in 2019 is accurate. The Fed is currently hiking rates into a consumer spending growth slowdown. That excess hawkishness can’t keep going for much longer.

Tariffs Are Being Discussed More

We don’t yet know how the tariffs are affecting the economy and earnings. The first step towards figuring out how they are affecting results is listening to what firms are saying on their conference calls. As you can see from the chart below, the number of firms discussing tariffs on their conference calls has increased to 45. This is out of 162 firms which had conducted their conference calls by April 25th. 19 of these firms were industrials, 6 were consumer discretionary, 4 were in the financial sector, and 4 were in healthcare. The great news is that 25 firms said there wouldn’t be an impact to earnings.

19 firms were worried that the tariffs could hurt customers, increase inflation, and slow the economy. That isn’t worrisome because earnings were great and expectations are still high. These worries are justified since tariffs add uncertainty to the economy. However, there is a massive difference between worries and actual negative effects. The sector most likely to be hit is the industrials. That’s not great because we’re already seeing slowness in manufacturing. The level of inflation has been increasing throughout the economy especially because of rising oil prices. Generally, inflation increases in the late stages of the business cycle. Therefore, it will be tough to distinguish the inflationary effects of the tariffs in the overall numbers.

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Finally, 12 of the firms which discussed tariffs stated they were uncertain about how the tariffs will be implemented and the potential impact of future tariffs. The most pressing uncertainty about the steel and aluminum tariffs is which countries will see their exemption status extended. I find it remarkable that the White House commented on Monday that the decision on which countries will have their exemption extended hasn’t been made even though the deadline is Tuesday. The most likely reason behind this is that deadlines inspire negotiation. The exemption status is all about whether negotiations have been pushed ahead at a reasonable speed. I understand how negotiations work, but running the government on a tight schedule is tough because it isn’t nimble like a private sector company. Specifically, Canada and Mexico should get an extension because of the progress in their negotiations. South Korea has agreed to permanent quotas. It’s uncertain how the negotiations with Brazil, Argentina, and Australia are going. President Trump has praised Australia because it has a trade deficit with America.

Conclusion

I’m concerned about why investors are so worried despite the great earnings and sales results in terms of year over year growth and beating expectations. If investors are concerned about the rising 2 year treasury yield, it means this bull market is nearly over because the 2 year yield won’t stop rising until a recession occurs. If this is just short term noise, stocks can increase for the rest of the year and possibly make new highs. Finally, if the deceleration of organic sales growth is the problem, industrials will be weak for the foreseeable future because the global economy is seeing a growth slowdown in manufacturing.