3Q Corporate Results Were Great. The Outlook for 2019 Looks Far Too Optimistic

Summary: Overall, corporate results in the third quarter were excellent. S&P sales grew 11%, earnings rose 30% and profit margins expanded to a new all-time high of 12.2%.

Fundamentals have been driving the stock market higher, not valuations: earnings during the past 1 year and 2 years have risen faster than the S&P index itself (meaning, valuations contracted). The strong growth in company profits is not due to a net share reduction (e.g., buybacks) either.

Looking ahead, expectations for 10% earnings growth in 2019 looks far too optimistic and will likely be revised downward as the substantial jump in margins this year is unlikely to continue. Even maintaining these margins will be a stretch, and earnings are at risk of falling. Dollar appreciation and declining oil prices are additional headwinds.

Valuations are now slightly below their 25-year average. They are not cheap, but the excess from early 2018 has been worked off. If investors once again become ebullient, there is room for valuations to expand. With earnings growth at risk, the key for share price appreciation in 2019 is likely to hinge on valuations expanding.

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90% of the companies in the S&P 500 have released their third quarter (3Q18) financial reports. The headline numbers are very good. Here are the details:


Sales

Quarterly sales reached a new all-time high, growing 11% over the past year. On a trailing 12-month basis (TTM), sales are 10% higher yoy, the best growth in 12 years (since 2006; all financial data in this post is from S&P). Enlarge any image by clicking on it.

Interview With Financial Sense on Macro Risks and The Market Correction

We were interviewed by Cris Sheridan of Financial Sense on November 12th. During the interview we discuss the macro-economic environment, specific risks that are unfolding and current market technicals as stocks suffer their second correction in 2018. One theme of our discussion is what to look for over the next several months.

Our thanks to Cris for the opportunity to speak with him and to his editor for making these disparate thoughts seem cogent.

Listen here.

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Fund Managers' Current Asset Allocation - November

Summary: Although US equities are up about 2% in 2018, Europe is down 10% and emerging markets are down more than 15%. Part of the reason: fund managers came into 2018 very bullish, with cash levels at 4-year lows and allocations to global equities at 3-year highs.

How have fund managers responded to an increasingly tough environment for equities?

In one respect, they are still bullish: global equity allocations are still 31% overweight. Into the major lows in 2011, 2012 and 2016, fund managers were underweight. Allocations could easily fall much further before global equities reach a bottom.

But in most other respects, fund managers are already very bearish:

They are overweight cash (by nearly one standard deviation), which is typically a tailwind for equities.

They view the US dollar as the most overvalued in 12 years, which has a very good track record of marking a turn to dollar weakness, a tailwind for US multi-nationals as well as ex-US equities.

Their profit expectations are the most bearish in 6 years, and at a level which also marked equity lows in 2010, 2011, 2012 and 2016. 

Their global macro growth expectations are the most pessimistic in 10 years, more than at the major equity bottoms in 2011 and 2016.  

A third believe the world's largest equity benchmark, the S&P 500, has already peaked. This number holding this view has doubled in just one month.

They believe 'value' will outperform 'growth' stocks; similar peaks (in 2009, 2014, 2016 and 2017) marked excellent times to be long equities, especially growth stocks. 

  

The US is the most favored region in the world. That's not surprising: during a global equity sell off, the US is usually regarded as the safest haven. It should underperform. Europe is the most hated region and is likely to outperform.

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Among the various ways of measuring investor sentiment, the Bank of America Merrill Lynch (BAML) survey of global fund managers is one of the best as the results reflect how managers are allocated in various asset classes. These managers oversee a combined $600b in assets.

Our sincere gratitude to BAML for the use of this data.

The data should be viewed mostly from a contrarian perspective; that is, when equities fall in price, allocations to cash go higher and allocations to equities go lower as investors become bearish, setting up a buy signal. When prices rise, the opposite occurs, setting up a sell signal. We did a recap of this pattern in December 2014 (post).

Let's review the highlights from the past month.

Overall: Relative to history, fund managers are overweight cash and neutral equities. Enlarge any image by clicking on it.

Within equities, the US is overweight while Europe, in particular, is underweight. This is a significant change from the past year.

A pure contrarian would overweight European equities relative to the US and underweight cash. 

Weekly Market Summary

Summary:  US equities rallied more than 6% from the October 29 closing low, but have since fallen back 3%. This is likely part of the "low retest" that accompanies most market corrections; "V-bounces" are not the norm.

The trend is bearish, but it is at odds with the solid economic environment. That conflict almost always ultimately resolves in favor of the bulls. By some measures, investor sentiment is among the most bearish since March 2009; even in a bear market, equities will experience a strong rally before rolling over. Seasonality is a substantial tailwind through year-end. Risk-reward over that period is again skewed higher.

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After falling 10% during October, US equities have rallied the past two weeks, with SPX gaining more than 2% each week. NDX fell 3% today but it is up the most - about 7% - so far in 2018 (table from alphatrends.net).  Enlarge any chart by clicking on it.

November Macro Update: New Employment Among Highest Since 2000

Summary: The macro data from the past month continues to mostly point to positive growth. On balance, the evidence suggests the imminent onset of a recession is unlikely.

The bond market agrees with the macro data. The yield curve has 'inverted' (10 year yields less than 2-year yields) ahead of every recession in the past 40 years (arrows). The lag between inversion and the start of the next recession has been long: at least 8 months and in several instances as long as 2-3 years. On this basis, the current expansion will likely last into mid-2019 at a minimum. Enlarge any image by clicking on it.