With all the crazy action in the markets, I’m recapping the latest earnings results a bit later in the week than usual. The big change this week was the acceleration in analysts’ estimates for Q1 earnings, full year 2018 earnings, and 2019 earnings. This was expected because many analysts waited until after firms reported Q4 results to update their models to include the effects of the tax cuts. The savings are dropping straight to the bottom line. As you can see from the chart below, estimates for Q1 earnings in the first month of the quarter are up 4.9%. That’s a big deal because usually the earnings expectations fall in this period. This is the biggest improvement in estimates since FactSet started calculating these estimates in April 2002. That’s means this is the best month in two business cycles. The 10 year average decline in the first month’s earnings estimates is 2.5%. There probably would have been a less than normal decline without the tax cut because recent quarters have been solid. Q1 earnings growth is now expected to be 16.9% and revenue growth is expected to be 7.1%. This shows the strength of the tax cut effect because it improves margins more than revenues.

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The improved estimates for the full year are even more impressive than the Q1 estimate improvements. As you can see from the chart below, the aggregate 2018 earnings estimates increased 5.3% in January, going from $147.23 to $155.09. This is the largest increase since at least 1996 which is when FactSet started calculating these estimate changes. The 2019 earnings estimates increased from $169.09 to $171.89. Now the S&P 500 has a 2019 PE multiple of 15.7. A declining stock market and increasing earnings estimates gets the multiple to shrink quickly. The main question investors need to consider is when the earnings estimates fully reflect the impact of the tax cuts. Once they do, I expect a moderate decrease in estimates like usually happens. However, because I think there’s still more upside in estimates because the tax cuts aren’t fully in the numbers, that final decline might be to a higher result than the current estimate. The Shiller PE will be perennially high if the corporate tax rate stays this low.

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I reviewed the forward estimates in depth because that’s where the action has been. However, the recent Q4 reports were also great. According to S&P Dow Jones, out of the 248 firms which reported earnings, 77.02% beat estimates, 13.71% missed estimates, and 9.27% met estimates. The historical average beat rate is 68.58%. The sectors with the best beat rate were healthcare, technology, and financials which had beat rates of 87.5%, 85%, and 84.78% respectively. The blended 10.2% S&P 500 operating margin is the highest ever. The technology sector dominated earnings as 27.88% of S&P 500 Q4 operating earnings came from that sector. This torrid earnings growth allows these stocks to increase without having high multiples. The 2018 estimated operating PE for the tech sector is 19.4. That’s only slightly higher than the index’s PE multiple which is 18.28. In terms of year over year Q4 blended sales growth, the energy sector did the best as it had 35.27% growth. Tech revenues were up 14.6% and the overall market had 9.02% sales growth. Energy’s operating margins increased from 0.55% in Q4 2017 to 4.28% in Q4 2018.

Senate Agrees To A 2 Year Budget Deal

Mitch McConnell announced he made a deal with the Senate Democrats to fund the government for the next 2 years. The agreement avoided the shutdown, increased defense and non-defense spending, and raised the debt ceiling until March 2019. The defense spending increases $80 billion in 2018 and $85 billion in 2019. The non-defense spending increases $131 billion. This agreement has gotten the government past any budgeting issues until after the midterm elections.

As per usual, there’s still an issue to overcome before this gets done. House Minority Leader, Nancy Pelosi announced she will be against this deal until House Speaker Paul Ryan commits to fix the DACA program which expires in March. The Democrats got another extension of the Children’s Health Insurance Program. This deal extends the program another 4 years after the recent deal extended it for 6 years. This deal seems like a win for the Democrats. I expect Paul Ryan to make some sort of agreement to work on DACA which allows Nancy Pelosi to support this deal. I expected the parties to work on a DACA solution anyway, so I think Nancy Pelosi is hand wringing.

Bond Selloff Resumes

This plan is great news for stocks because it’s one less thing for investors to worry about. There won’t be anymore short term deals to keep the government open. Given how contentious the debates between the parties have gotten, it’s a mini miracle that they worked together on a big deal to keep the government funded. The negative of this plan is it does nothing to fix the expanding fiscal deficits. Expanding deficits, increasing inflation, and the Fed unwinding the QE program all mean rates will increase. After recently correcting during the stock market crash, yields have made new highs for this cycle. The 10 year bond yield was up about 5 basis points on Wednesday to 2.85%. We are nearing the peak in 2014 which saw rates at 3%. The more powerful the uptrend in yields, the less the earnings growth I mentioned earlier matter.

The good news is that the difference between the 10 year bond yield and 2 year bond yield has risen to 71 basis points. Essentially, this pushes back the chances of a recession, but pushes forward multiple compression. The chance of rate hikes declines when there are strong stock market corrections. That could be a problem because the Fed wants to raise rates so it can cut them in the next recession. The potential fiscal stimulus will already be hamstrung because a stimulus was put in place at the end of this expansion. Therefore, a dearth of rate cuts in the next recession would be particularly problematic.