Looking ahead, analysts' expectations for 10% earnings growth in 2019 have been revised down to just 2%. This estimate will be about right if margins can be maintained at the current level and the dollar doesn't further appreciate, but another drop in oil prices could cause earnings growth to decline towards zero.
For 2020, analysts currently expect growth of 5% to sales and 11% to earnings. This is too optimistic. Assuming no change in the dollar, oil and margins, earnings growth is likely to be halved. Margin compression (likely) would lower growth much more.
Valuations are now back to their 25-year average. They are not cheap, but if investors once again become ebullient, there is room for valuations to expand. With earnings growth likely to be negligible, the key for share price appreciation in 2019 (and 2020) is likely to hinge almost entirely on valuations expanding.
* * *
93% of the companies in the S&P 500 have released their second quarter (2Q19) financial reports. The headline numbers were fine, but growth has slowed. Here are the details:
Sales
Quarterly sales grew 5% over the past year, to a new all-time high (ATH). On a trailing 12-month basis (TTM), sales were 7% higher yoy (all financial data in this post is from S&P). Enlarge any image by clicking on it.
The arrows in the chart above and those that follow indicate the period from 2Q14 to 1Q16 when oil prices fell 70% and the US experienced an "earnings recession." The negative affect on overall S&P sales (above) and the energy sector alone (below) is easy to spot.
The six sectors with the highest weighting in the S&P grew an average of 8% in the past year (box in middle column) and, since the peak in oil in 2Q14, their sales have grown an average of 39%. In contrast, energy sector sales have declined 29% (far right column).
Excluding the volatile energy sector, sales for the remainder of the S&P have continued to trend higher at about the same rate over the past 9 years (blue line; from Yardeni).
The dollar has been a headwind for sales growth: in the past year (thru 2Q19), the dollar appreciated by 6%; this accounts for about a 3 percentage point decline in corporate sales growth. For the current quarter (3Q19), the dollar is pacing a more modest 3% yoy appreciation.
How does the dollar impact sales growth? Companies in the S&P derive about half of their sales from outside of the US. When the dollar rises in value, the value of sales earned abroad (in foreign currency) falls. If foreign sales grow 5% but the dollar gains 5% against other currencies, then sales growth will be zero in dollar terms. The chart below compares changes in the dollar (blue line; inverted) with growth in S&P sales (red line): a higher dollar corresponds with lower sales (from Yardeni).
Earnings and Margins
Operating EPS grew 4% over the past year on a quarterly-basis and 10% on a trailing 12-month basis (TTM). GAAP EPS was the same: 4% quarterly growth yoy and 11% growth TTM. More on the distinction between operating and GAAP EPS below.
EPS fell from its recent ATH in 3Q18 into a low in 4Q18, but then rebounded strongly the last two quarters.
The arrows in the next chart again indicate the period when oil prices fell 70% between 2014 and 2016. The improvement in total EPS since then comes with energy sector EPS at one-third of its level in mid-2014, but note how energy EPS has been nearly halved in the past 9 months.
Margins reached a peak of 12.1% in 3Q18, fell to 10.1% in 4Q18 and have since rebounded to 11.5% in 2Q19.
Excluding the energy sector, margins rebounded to 12.1% in 2Q19 from 10.2% in 4Q18, but may have peaked in 3Q18 at 12.6%.
The margins of the largest sectors are flat over the past two years, with the exception of financials and technology, although these have also flattened in the past year.
The fall and rebound in margins in the past year is most apparent in the financial sector, which fell from 17.7% in 3Q18 to 8.5% in 4Q18 before recovering to 17.4% this quarter.
There are some popular misconceptions that are regularly cited with respect to corporate earnings.
First, companies have been accused of inflating their financial reports through a net reduction in shares through, for example, corporate buybacks. In reality, however, 89% of the growth in earnings in the S&P over the past 9 years has come from better profits, not a net reduction in shares. Better profits have driven growth, not "financial engineering."
That has been true over the past 17 years, during which the net change in corporate shares has accounted for just 4% of EPS growth (from JPM).
In fact, despite record buybacks, the difference between EPS and profits has been consistently narrow.
Second, equity prices are said to have far outpaced earnings during this bull market. In fact, better profits accounts for about 72% of the appreciation in the S&P over the past 9 years. Of course valuations have also risen - that is a feature of every bull market, as investors transition from pessimism to optimism - but this has been a much smaller contributor. In comparison, 75% of the gain in the S&P between 1982-2000 was derived from a valuation increase (that data from Barry Ritholtz).
Over the past 2 years (since 2Q17), during which time the S&P has risen about 20%, earnings have risen 30%, i.e., faster than the S&P index itself thereby accounting for more than 100% of price appreciation. The same is true over the past 1 year (from JPM).
Third, financial reports based on "operating earnings" are said to be fake. This complaint has been a feature of every bull market since at least the 1990s. In truth, the trend in GAAP earnings (red line) is the same as "operating earnings" (blue line).
It's accurate to say that operating earnings somewhat overstate and smooth profits compared earnings based on GAAP, but that is not new. In fact, the difference between operating and GAAP earnings in the past 27 years has been a median of 10% and the recent history has been not much different (it was 14% in the most recent quarter). Operating earnings overstated profits by much more in the 1990s and earlier in the current bull market. The biggest differences have always been during bear markets.
Outlook for 2019 and 2020
Looking ahead, expectations for 10% earnings growth in 2019 have already been revised down to 2%. In 2020, earnings growth is expected to be 11%, which is too optimistic and likely to be halved. Sales growth is expected to be 4% in 2019 and 5% in 2020 (from FactSet).
There are 5 considerations with a strong bearing on forward sales and earnings. Most of these appear likely to be a headwind in 2019 and maybe also in 2020.
First, as a baseline, it is reasonable to assume that corporate (non-energy) sales growth will be largely similar to the nominal economic growth rate of 4-5%, excluding currency effects. Right now, this seems achievable (from the OECD).
Second, the dollar weakened from the end of 2016 to early-2018 (a tailwind to growth) but has since appreciated 9%. That means that currency effects are now a headwind to growth. With half of corporate sales coming from abroad, even a small 3% appreciation in the dollar (the current pace for 2019) could cut 1.5 percentage points off sales growth this year.
Third, the price of oil was tracking more than a 30% yoy gain until October 2018; the price then fell 30% into year end. In 1H19, the average price of oil was 13% lower than a year earlier; in other words, the energy sector became a headwind to overall sales and EPS growth. The average price so far this year is $57; below $65, oil will remain a headwind in 2019.
As we have seen, the direct impact of oil prices on the energy sector is far more important than any ancillary affects on other sectors. As an example, consider this: the price of oil fell from over $100 to under $50 between mid-2013 and mid-2016 but non-energy sector operating margins were 10% in both instances. In short, lower oil prices are a net negative for sales and earnings.
Fifth: the biggest risk to earnings in 2019 is margin contraction. For earnings to grow as fast as sales, margins have to be maintained. But after trending higher over the past 7 years, margins jumped 140bp in 2018. This was a massive rise and sustaining that level (let alone expanding margins further) seems unlikely, especially given the fall in margins since 3Q18.
In fact, average margins in 2018 were 11.3%, the same as in 1Q and 2Q19. If that level is maintained throughout 2019, earnings growth will be 4% (down from 22% in 2018). If the dollar continues to appreciate, that growth could fall to 2%. If oil remains under $65/barrel, earnings will fall further.
Valuation
At the end of 2018, the combination of 22% earnings growth and a 6% fall in equity prices left valuations at 14.4x, the same level as in 2010 and well below their 25-year average. The rally since then has brought valuations only slightly above average (from JPM).
Valuations are not cheap, but if investors once again become ebullient, there is room for valuations to expand. Why? When investors become bullish (blue line), valuations rise (red line). Investors had been pessimistic in early 2016 and then became far too optimistic at the market peak in January 2018. Importantly, that was greatly reset by the end of December 2018 and while sentiment has since rebounded, it has not reached an extreme (from Yardeni).
It's hard to believe that investors have already reached peak bullishness. Fund flows into equity mutual funds and ETFs was strong before both the 2000-02 and 2007-09 bear markets, and even before the 2015-16 mini-bear market (blue circles). In comparison, fund flows have been negative for 5 of the past 8 quarters (red circle; from JPM).
Valuations are influenced by more than investor psychology. Part of the reason equities have become more expensive over time is rising corporate profitability. Margins have reached successive new highs with each economic cycle over the past 3 decades: they are now more 100bp higher than in 2007, and that peak was more than 100bp higher than in 2000. Higher profitability (and growth) is typically rewarded with higher valuation multiples (from JPM).
While it is objectively impossible to know when or at what level margins will peak for this cycle, it's a reasonable guess that the cycle peak was in 3Q18.
Importantly, valuations have almost no bearing on the market's 1-year forward return (left side). But over the longer term, current valuations suggest that single digit annual returns are odds-on (right side; from JP Morgan).
In summary, corporate results in the second quarter of 2019 were fine, but growth has slowed. Sales and earnings were up were 5% and 4% yoy, respectively. Margins rebounded from the end of 2018 but are still below the cycle high made in 3Q18.
Looking ahead, analysts' expectations for 10% earnings growth in 2019 have been revised down to just 2%. This estimate will be about right if margins can be maintained at the current level and the dollar doesn't further appreciate, but another drop in oil prices could cause earnings growth to decline towards zero.
For 2020, analysts currently expect growth of 5% to sales and 11% to earnings. This is too optimistic. Assuming no change in the dollar, oil and margins, earnings growth is likely to be halved. Margin compression (likely) would lower growth much more.
Valuations are now back to their 25-year average. They are not cheap, but if investors once again become ebullient, there is room for valuations to expand. With earnings growth likely to be negligible, the key for share price appreciation in 2019 (and 2020) is likely to hinge almost entirely on valuations expanding.
