This is a somewhat unusual earnings season with a lot of moving parts. Expect to hear about tax cuts, buybacks, big revenue gains, trade wars and very high future earnings expectations. It’s all a rather volatile stew, and the stock market is clearly expecting a positive outcome.
The stakes are high, with 20 percent profit growth expected in the second quarter and similar numbers expected for the rest of the year.
Here’s what it will be about:
1. The emphasis will be on fundamentals and on the expanding economy, and less on the tax cuts. Despite what people think, the 20 percent gain in earnings is not just because of the tax cuts. Here’s how that 20 percent profit growth breaks down, according to Goldman Sachs: 7 percentage points come from tax cuts and 13 percentage points come from pretax gains. So 35 percent of the gains are from tax cuts, and 65 percent from pretax gains.
2. The quarter’s theme will be about revenue growth, not about cost cutting. Here’s another old chestnut I keep hearing: “All the profits are coming because companies are cutting costs, they’re not growing top line.” That story is so 2016.
Revenue — top-line growth — has dramatically improved in 2018.
Q1: up 8.4 percent
Q2 (est.): up 8.1 percent
Q3 (est.): up 7.9 percent
Q4 (est.): up 6.0 percent
That 8.1 percent estimated increase in second quarter revenue means that the majority of the pretax profit is coming from revenue growth, not cost cutting or productivity gains.
3. You will hear more about investment spending, including buybacks, dividends and (from a small group of companies, mainly Apple) repatriation of profits. Announced buybacks are already close to $600 billion this year and many are estimating it will surpass $800 billion this year, a record. (There were a little more than $500 billion in announced buybacks in 2017).
Unlike many prior years, buybacks are reducing overall share counts this year. Dividend growth has been more modest, but has been increasing as well.
4. The trade war commentary will be mixed. Pay close attention to comments from auto manufacturers and retailers, all of whom will likely have trouble passing on tariff cost increases and will be the first to warn investors.
Elsewhere, the Federal Reserve has already signaled that trade war concerns may eat into what otherwise looks like a strong increase in capital spending. Listen carefully. My bet is we will hear a lot about “concerns” but not a lot of concrete commentary like, “We are cutting cap ex spending 10% over trade concerns.” Not yet.
5. The key to market momentum is to maintain guidance given earlier in the year. I call it “The 20 percent club.” It is a rare year when the S&P 500 will see earnings growth of 20 percent or more for each quarter, but that is exactly what is happening:
Q1: up 26.6 percent
Q2 (est.) : up 20.8 percent
Q3 (est.) : up 23.2 percent
Q4 (est.) : up 20.2 percent
Source: Thomson Reuters
The secret to keeping the market up this year is to keep the guidance up. “If we see earnings estimates for the third and fourth quarter drop below 20 percent growth, that would be bearish in my mind,” Nick Raich from Earnings Scout told CNBC.
The early signs are good. Some 23 companies have reported earnings so far, and they are seeing earnings gains of 24 percent and revenue gains of 12 percent, well above expectations.