Earnings Revisions - Estimates Weaken

Just because earnings season is over doesn’t mean earnings estimates don’t matter.

Since investors are always projecting future cash flows, estimates always matter. They aren’t set in stone. The rate of change of estimates gives us an idea of where the economy is going and where stocks should be headed.

It’s one part of my analysis and all the analysis for investors who don’t believe in following macroeconomics.

As you can see from the chart below, Q2 ended up with 26.58% earnings growth which is fantastic. It doesn’t matter much now though.

The estimates for Q3 have been declining as they peaked at 23.82% on July 1. They now show earnings growth of 22.27%.

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Earnings growth has always been expected to peak in Q3. Now it looks like results will need a substantial beat to get above Q2 growth.

That’s not a huge deal either way because as long as earnings grow, stocks should be fine. If earnings growth misses or beats the rate in Q2, the media will be discussing the peak in growth just like it did in Q1. However, with more fervor, because Q4 is going to have start a sharp declaration.

Earnings Revisions - The most important aspect to understand is that Q4 earnings estimates are already important for forecasting equity performance. 

It’s ridiculous to think the stock market is going to correct based on something most investors knew 6 months ago. Everyone knows Q4 growth will be in the teens, but where it ends up is important.

The rate of change is important because stocks become more expensive if earnings growth is 15% instead of 19%.

As you can see in the chart below, investors are in a perilous situation because the stock market is near its record high. Also, there are many negative earnings revisions and few positive ones.

The situation is even worse than January which is disconcerting since stocks fell 10% after that peak. It took until August for them to recover. The upside is certainly capped for stocks unless the fundamentals improve.

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Earnings Revisions - Small Monday Rally

After a poor week, the stock market improved on Monday. The S&P 500 and the Nasdaq broke their 4-day losing streaks increasing 0.19% and 0.25% respectively.

Tesla was the biggest winner in the S&P 500 as it increased 8.5% because of a positive research note. I think this was all about timing for the stock because it was very oversold.

It was looking for anything positive to rally on. The call by Bernstein was short-term oriented, meaning it has nothing to do with whether Model 3 can bring the company to profitability within the next 2 quarters.

The best sectors were real estate and utilities which were up 0.54% and 0.58%. The 3 losing sectors were health care, financials, and energy which fell 0.31%, 0.08%, and 0.02%.

This action appears to be interest rate focused again. However, there wasn’t much action in treasuries as the 10-year yield was flat at 2.94%. And the 2 year was up one basis point to 2.71%.

The 2-year yield is at a cycle high, pushing the difference between the yields to 23 basis points.

Earnings Revisions - The Cash Was Brought Back

As you can see from the chart below, there was $300 billion in cash brought back to America. This cash was held abroad by U.S. multinational corporations.

One-third of the $1 trillion in cash that was held overseas. This was because of the very high U.S. corporate tax rate is now in America.

The capital hoard likely won’t get that high again ever after the repatriation holiday because the corporate tax rate was also lowered.

A lot of the money went to buybacks, partially explaining why buybacks are at a record this year.

For the top 15 overseas cash holders, about $55 billion of the repatriated capital was used for buybacks.

This is over double the amount used on buybacks by those firms in Q4 2017 ($23 billion).

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Earnings Revisions - Sentiment Too Hot

If you want to see overzealous sentiment before claiming another correction like January is coming, look at the charts below.

As you can see, the percentage of bullish investors nearly hit 60. The total bearish investors are near 20%. The sentiment is less extreme than January. However, it doesn’t look promising for the bulls.

The bull-bear spread and bull-bear ratio aren’t near records, but they do show excessive optimism.

As you can tell, we have slightly less optimism, but worse earnings revisions.

It’s worth noting that because stocks are higher than in January doesn’t mean stocks will fall further. That’s a common mistake inexperienced investors make.

Stocks aren’t subject to gravity in that they need to fall as much as they increased. There’s a plethora of factors which will determine the size of this correction. I’m confident it isn’t over after this slight rally on Monday.

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Earnings Revisions - Stocks Aren’t Gravity

Here’s a basic, but important stat which shows stocks aren’t subject to gravity.

The stock market is up 95% on a 10-year rolling basis. To be clear, the S&P 500 should always go up because it takes out the losing firms and puts in new winners.

It’s a trend following/momentum bet to buy the S&P 500 index. It has been a great bet over the past few decades as it’s a net benefit to miss out on the end of a company’s lifespan and the beginning.

The beginning has rapid growth and the end is when the firm folds.

Earnings Revisions - Conclusion

Stocks have rallied this year on the back of repatriated capital and strong earnings growth.

I’m not saying stocks will end the year negative. However, a pullback greater than what we have seen thus far is in order according to the sentiment indicators and the analysts’ revisions.

This is a healthy correction in the midst of the year with near double-digit gains. Next year looks more disconcerting. And if the yield curve stays normal, it could end without including the first bear market in 9 years.