Despite many positive signs for the economy and earnings, a small but significant group is insisting we are near “peak earnings.”
They believe that earnings will be topping out in the next few quarters and the rate of growth in earnings will slow.
Taking their argument a step further, when the market figures this out — perhaps not this quarter but certainly within the next quarter of so — stocks will begin to droop.
How real is that concern?
“You will have more difficult comparisons in 2019,” Christine Short, who follows corporate earnings for Estimize, told CNBC. “The benefits from tax reform will wane some in 2019. So you may see slowing growth, but does it mean stocks will be down? Not necessarily.”
Everyone on the Street knows we are expecting phenomenal earnings growth this quarter. Estimates are looking for gains of 18.6 percent, the strongest growth since 2011.
The numbers aren’t just strong for this quarter, they are strong for the whole year.
Q1 : up 18.6 percent
Q2: up 19.8 percent
Q3: up 22.2 percent
Q4: up 19.2 percent
Source: Thomson Reuters
To be clear, 20 percent earnings growth is rarely seen.
No matter. It’s all over, according to what I call the Earnings Peakers.
John Lynch, chief investment strategist for LPL Financial, wrote in a recent note to clients: “EARNINGS PEAK? The near 20% earnings growth rate expected for the quarter may be as good as it gets for the rest of the current business cycle (without knowing how much longer the cycle will last). Consensus estimates indicate several more quarters near that pace, but it will be difficult for companies to maintain that at this relatively late stage of the economic cycle. As 2018 progresses, market participants may start to look toward slower growth rates in 2019 when the annual bump from the new tax law will have passed and growth comparisons get more difficult.”
Part of this statement is true. Earnings growth is expected to go from 20 percent this year to “only” 10 percent next year. This is not a drop in earnings. Earnings would still be at record highs, but the rate of growth in earnings (the delta, as quants like to say) is slowing.
And that, Earnings Peakers say, will be enough to halt the market advance.
They got ammunition on Friday when bank earnings came in strong (Wells Fargo missed on revenue), and the stocks sold off. Rather than ascribe it to “sell on the news,” which is the most likely explanation after a strong week, some insisted it was a warning sign.
Well, maybe. But my view is that several factors will likely keep stocks strong for at least the next couple of quarters.
For years, the bitter complaint among investors was that we saw earnings growth through cost cutting, and not revenue gains. That’s no longer the case. Revenue has been growing for a year and is expected to continue to grow in the mid- to high-single digits for the rest of the year.
Revenue growth is only part of the “good news” story around stocks. It’s early in the earnings season, but two stories are starting to emerge that may provide additional fuel for a stock rally: 1) growing signs that tax cuts are translating into real bottom line growth, and 2) share repurchases appear to be accelerating.
Let’s talk about tax benefits first. Most companies have not reported yet, but fortunately we have a small army of analysts whose job it is to make a stab at the impact tax cuts might have on the companies they cover.
Here’s the way to look at this: Total profit for the S&P 500 is expected to increase 16.7 percent, according to Thomson Reuters.
We don’t know exactly how much of this increase is the result of tax cuts. However, if we look at estimates of earnings before interest and taxes, which removes the effect of tax payments, the S&P is expected to see an increase of 8.6 percentage points.
The difference between total profit (up 16.7 percent) and EBIT (up 8.1 percent) is roughly the effect of taxes. And that difference is 8.6 percent. For the most part, that spread historically has been fairly negligible, usually no more than 1 or 2 percentage points. But now it has jumped up significantly.
David Aurelio, who tracks corporate earnings and revenues for Thomson Reuters, believes “the majority of this is due to tax cuts.”
That is a big difference. And most of that can reasonably be assigned to the impact of tax cuts.
“You are seeing a very strong earnings quarter on its own, but it is amplified by tax reform, and that is making it extraordinary,” Aurelio told me.
Finally, let’s look at share buybacks. Early indications are that buybacks will be up significantly this year, perhaps 50 percent or more. But once again, we can see what analysts are anticipating. Net income is expected to be up 16.7 percent, but earnings per share is expected to be up 18.5 percent.
Why is there a difference? Net income is total profit. Earnings per share is the profit allocated to each share. In theory, if net income is up 10 percent, earnings per share should be up 10 percent, unless a company is buying back shares.
If a company buys back shares, the net income stays the same, but the earnings per share goes up.
That’s exactly what we are seeing. The difference between the two is 1.8 percentage points, and it is reasonable to assume that is what earnings buybacks are doing to boost earnings.
We are seeing similar numbers in quarters for the rest of the year. You may say that the markets have therefore already priced this in, but the chances are that buybacks will be increasing.
My point is that there is a good chance that tax cuts and earnings buybacks are not fully priced into the market.
Another potential help: “Stocks were really expensive, and now the market is cheaper,” Estimize’s Short told CNBC. “The banks are trading at 12 times forward earnings — that’s a really low number. And the S&P 500 P-E ratio is below 17, which is the historical average. There’s a real potential for multiple expansion. And no one has lowered earnings guidance yet,” she said.
We may not be at peak earnings, after all.