The cut in corporate tax rates added about 8% to S&P 500 corporate earnings growth in 2018 while other elements of the 2017 tax reform provided an additional boost last year. That is not going to happen again. So the slowdown in earnings growth in 2019 is really not as big as it seems.- Jeff Buchbinder – LPL Senior Equity Strategist
In this week’s Market Signals podcast, our Research strategists preview the upcoming earnings season.
With earnings growth for S&P 500 companies in the mid-teens, the latest corporate earnings season could be a good one. Fueling that expectation is solid economic growth, tax cuts, and sharply higher energy sector profits.
While things are off to a good start overall, it’s early. Financial companies have benefited from improved net interest margins on loans and a pickup in loan growth. However, the fourth quarter was challenging for the capital markets, leading to mixed results. Tariffs and slower growth in China and Europe remain key risks. Expectations for earnings have been lowered, but that could be setting up a likely upside surprise.
Looking ahead, the strategists see solid 6-7% earnings gains to $172.50 per share in S&P 500 earnings. That could support double-digit stock market gains this year. Though earnings growth is slowing, primarily because of the anniversary of the December 2017 tax cuts, a slowdown and contraction are two very different things.
Tune in to get our strategists’ take on what could be a strong earnings season. If you haven’t already, subscribe to Market Signals on your favorite digital channel to access future and past podcasts.
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John Lynch: Hello everyone. This is John Lynch, Chief Investment Strategist for LPL Financial and welcome to this edition of Market Signals Podcast. We're delighted to have you on today and today I am on with my good friend and colleague, Jeff Buchbinder, our Senior Equity Strategist up in Boston. Hello Jeff.
Jeff Buchbinder: Hi John, good to be with you today. How are you?
John Lynch: I'm well, hope you are.
Jeff Buchbinder: Absolutely.
John Lynch: On today's call, we'd like to specifically talk about corporate profitability. Jeff Buchbinder, regular listeners will know, is our earnings whisper at LPL Financial and he's done a great job over the years, been with the firm over 15 years and really has a great knowledge base of not only equities but also corporate profitability that drives equity. So we're going to spend the brunt of the call on that.
But I do want to emphasis, many of you heard Ryan Dietrich and I speak about this in the past, the market has rallied. We hit a low on Christmas Eve, the S&P technically did not slip into a bear market. The NASDAQ composite and the Russell 2000 and a handful of sectors did, along with a bunch of global equities but the S&P and the Dow did not. But nonetheless, I don't want to split hairs here but we do want to point out that the market has responded impressively, we're up about 10%. But Jeff, wouldn't you characterize this as having been the easiest 10% of the recovery?
Jeff Buchbinder: Oh absolutely. Regular listeners know we do follow the charts and-
John Lynch: When all else fails.
Jeff Buchbinder: ... technical analysis. Yeah, maybe so. Fundamentals matter more, especially over the long term. But in the short term, if you look at the charts, we saw the potential for some resistance here up in the 2600 to 2650 range on the S&P. So we're into that range and the next 10% will be a lot tougher.
John Lynch: Absolutely, absolutely. And I guess it was right around mid-December when you and I wrote that report talking about the triple bottom, which unfortunately did not hold. Triple bottom would've been at 2600 to your point, 22620 or so. And the market did not hold that so that's why we drop like a rock over the ensuing handful of weeks.
And why we say, good listeners, that the easy part is done is because when the market fails so quickly, there really was no base camp set up from 2600 to 2350 on the closing low for the S&P 500. So the climb back up was pretty easy, relatively easy if you will. But also we need to be mindful, as Jeff mentioned, 2600, 2620 or 2650 can be characterized as resistance for the S&P 500. Periods of previous market turmoil will tell you that what had once been support, quickly becomes resistance. And while 2600 had been support for so long, 2600 to 2650, right now, is resistance for the S&P 500 so that's something we have to mindful of.
We do believe we can chug through that resistance, it's not just a technical move. I think that at this point, the move higher needs to be accompanied by clarity on several areas. It appears we're getting good signals from the Federal Reserve, it does not appear they were going to be as aggressive as originally feared. We've been talking about that quite a bit. In fact, Jeff, you were at the presentation last October that kind of started off a lot of the concern when Jerome Powell gave a mixed message on interest rates. You want to comment on that?
Jeff Buchbinder: Yeah, sure. He, I'm sure would admit, that he made a mistake in saying that rates were a long way from neutral. So he's locked that back with help from his friends, not just current Fed governors but also former Fed chairs that he did the event with not long ago, and now is seemingly communicating effectively that the Fed will be much more flexible. That's really what the market wanted and it looks like it's unlikely that we'll get a hike here in March and we may not even get one at the meeting after that.
John Lynch: Absolutely. So I think clarity on interest rates will be really important for investors to keep in mind. But I also want everyone to think about, it's not necessarily ... There's a lot of speculation the Fed could actually cut in 2019, and we don't believe that's the case. The Fed has a lot of tools at their disposal. They can imply a pause, then they can pause. They can imply a reduction in the amount of assets being sold off their balance sheet and then they can enact fewer balance sheets, fewer securities rolling off their balance sheets. So there are several steps before a rate cut could occur, and we just don't think the fundamentals would support that. And consequentially, pause or close to being done should be sufficient for investors.
But not only will the Fed be important in market interest rates, but we think it's important to get clarity on trade as well. It appears that the Chief Negotiator from China will be in D.C on January 30th to begin negotiations. Legislatures in China are fast tracking legislation to end force technology transfers as well as protecting security intellectual property. So we think those are positive developments.
So you get a combination of path to progress on China, clarity on interest rates and then what we believe the most important driver of equity is corporate profits, Jeff. And corporate profits season has already begun for the fourth quarter and why don't you give us a little preview and review of what's occurred thus far.
Jeff Buchbinder: Yeah, sure John. So mix start for sure but it really hasn't dampened our optimism. It's really early, just a handful of companies and most of them have been financials. So really too early to call it a disappointment but we've had a little bit of a slow start in financials. We still think we'll get mid to maybe the mid to high teens growth for the quarter when all the numbers are in. But we have had a little bit of a miss on the financials. It was a very difficult quarter for the big investment banks, the big [inaudible 00:07:54] banks for that fixed income trading. I mean, just think back, John, to what the markets were dealing with in Q4. I mean, worse December since 1931 for the stock markets.
John Lynch: I can't un-see it.
Jeff Buchbinder: [crosstalk 00:08:06] weakness in the credit markets too. That was a tough environment for the big banks and the big brokerage firms that are trading these securities every day to navigate. And so a little bit of weakness is no surprise but that is weighing on the overall numbers. And it's probably going to take another week or two of results before we can call this an upside surprise.
John Lynch: But what's curious about the financials, Jeff, maybe you could elaborate a little more. Obviously the big money center banks, if you will, got hit on trading and stuff like that in the quarter. But the bread and butter, the lending business, held up relatively well didn't it?
Jeff Buchbinder: It did, yeah. There's the upside surprise so far is lending has been pretty strong. We often talk about net interest margins for banks, it's basically a profit margin on a loan. The difference between what it costs the bank to get the funds and the lending rate, the rate which their customers borrow from them and that actually has improved here recently. Even though you read the papers, you see everybody talking about a flat yield curve or nervous about inversion. The environment for banks, in terms of the yield curve, is actually gotten a little bit better and that was frankly a surprise to me. And then maybe another surprise, positive surprise, is that lending activity was pretty good. So maybe some companies are moving away from the brokerage firms, away from the capital markets, and just borrowing old school from the bank.
John Lynch: Benefit of a diversified business model, right? And you talk about that net interest margin and I think that's really key, right, the traditional bank model is to borrow short lend law. But this goes back to the Fed and to the degree that Fed Chair Powell has been discussing the possibility of pausing, or that's what's been implied at least. But he's outright stated that balance sheet reduction will still continue.
So for our listeners who don't pay too much attention to that like you and I do every day, balance sheet reduction, letting assets on their balance sheet mature or outright sold and consequentially that drives up market interest rate. That drives up longer interim interest rates because the Federal Reserve is in charge of the overnight lending rate. Jeff, you and I and all of our listeners out there and all investors out there help determine market interest rates. So as the Fed allows assets to roll off its balance sheet and the Fed is no longer supporting or backstopping U.S Treasury auctions, those two factors have an upward bias for market interest rates. So to the degree that in of itself, or those two things in of themselves, causes the yield curve to steepen, the difference between two year treasuries and the 10 year treasury, consequentially that also can bode well for net interest margins can't it Jeff?
Jeff Buchbinder: Oh yes, absolutely. The list on the short end of the curve has helped because a lot of these banks and brokerage firms have a bunch of cash sitting on their balance sheet that's been earning nothing and now it's earning more. And that's great, 2 - 2.5 % in many cases. But then if you get on top of that higher longer term interest rate, like the 10 year treasure yield that everybody talks about, that's going to add to lending profitability as well. So the environments been very tricky for a lot of reasons, certainly the yield curve is one of those reasons. But we think that prospects are brightening for the financial sector here going forward. And I think the results, even though again the high level numbers for Q4 aren't great. I think what we've heard from all of these institutions suggesting that things are going to get better from here.
John Lynch: Sure. And if we look at it, maybe call it 10 - 12% range for 4th quarter profitability and I guess we've been tracking 3 or 400 base points above expectations for the last six quarters or so. Is that correct?
Jeff Buchbinder: Yeah, that's correct. There are several different sources of data that are a little bit different but [inaudible 00:12:32] at 14% and [inaudible 00:12:35] at around 12. But the upside has been in the neighborhood of 3 to 5% each quarter so that should put us in the mid-teens when all is said and done. But there are, at the same time, risks here, John. I mean we all know about, you mentioned them upfront, trade and slowing growth in China. Europe, certainly the economy there is weakening, not just the UK but Europe broadly. And it's probably going to be a little bit tougher to generate that big upside that we've been used to over the last several quarters.
John Lynch: That's right. Since S&P companies derive upwards of 40%, 38% of their profits from international sources so it's something we have to be mindful of.
We talked about financials, it's remarkable across the board. In the financials, healthcare, consumer discretionary, communication services, industrials, everybody's printing about 10% earnings growth this quarter, a little more. But the outlier, once again Jeff, is energy and energy continues to deliver, what, it looks like it'll be about a 70% earnings growth this quarter but the stocks just haven't reacted. Why is that?
Jeff Buchbinder: Yeah, well one of the reasons-
John Lynch: If you knew, you'd be a rich man, right?
Jeff Buchbinder: ... as we know collapsed late last year and the market, of course, priced that in. So even though you've got these big earnings gains in Q4, that's kind of yesterday's news and what really matters is 2019. And 2019 estimates have come down quite a bit because oil effectively went from 70 to 42 late last year and it was in a pretty short period of time.
Energy projects are really long term projects and when big [inaudible 00:14:30], right? And so when oil is moving around like that, it's certainly hard for companies to commit to start drilling more or pumping more or however they're getting it. So the market has reacted to that. Although energy's performed well, the stocks didn't perform well this year, had a difficult Q4, and estimates have come down quite a bit for 2019. Energy stocks tend to follow the price of oil much more than they tend to follow earnings.
John Lynch: Good point, good point. And from an economy standpoint, it's interesting, you never want to say, "It's different this time." Right? But it is different this time now that the U.S is the world’s largest energy producer and also the largest swing producers. So the whole idea that lower oil prices would result in lower gasoline prices, that bodes well for the consumer, right, because there's more money to spend. But to the degree that capital expenditures are so dependent on energy related investment, that also could impact economic growth negatively.
So we have to be very mindful of all those things. So looks like fourth quarter earnings will be a good number, the 2019 numbers get a little more challenging simply because comparisons are going to be so difficult. So what's your outlook for 2019 Jeff?
Jeff Buchbinder: Yeah, this big slowdown has gotten a lot of attention. We're looking at about 6-7% earnings growth next year, that's in line with consensus. But if you go back just two, three months ago, those expectations were north of 10%. So we've seen a big drop in earnings growth expectations from analyst and that's alarmed some people. But if you take a step back, it's actually pretty normal. On average you get several percentage points in estimate cuts every quarter anyway. We only got a percent or two more than the average. And certainly, the whole trade tariff situation with China makes this environment unusual, that's certainly one of the reasons we've had estimates cut as they have been because tariffs hurt company profit margins. But you also have the big revenue warning from Apple which certainly caused Apple's estimates to be reduced but it also had a spillover effect. So estimates have fallen but if you look at the reasons they haven't fallen more than they normally fall, I think it's pretty easy to get comfortable with an estimate in the sort of mid-single digit range for 2019.
John Lynch: Yeah, you wrote beautifully a couple weeks ago about a bear market discount without a recession for equities, and I think that's really important for investors to keep in mind.
We'll close with this comment or a few thoughts that the public discourse is that earnings are falling and we want to make sure our listeners and all our investors understand that the rate of acceleration in corporate profitability is slowing. But we are still looking record profits from 2018 growing at historically average rates or potentially slightly above historically average rates in 2019. Yet we're discounting record profits growing at historical averages, were discounting those at below average interest rates which enhances not only the present but future value of that earning stream.
We still believe, in spite of all the technical damage the market has endured the past month or so, we still believe in an environment for inflation is 2 - 2.5% and the Fed appears accommodative or at least pausing going forward. We can get earnings for the S&P 500 in the 172 - $172.50. And with a 2.5% type inflation top line number, we think we could trade about a 17 and a half price to earnings ratio on the market on that 172 and that gets us to fairly value the market S&P 500 right around that 3000 level.
So I know that might seem like quite a stretch now given all the markets endured and we recognize that is a challenge but get through this technical resistance, get clarity on China, clarity on the Fed, degree of profitability moving forward, then we think ... well, we don't believe it'll be a straight line, we think we can chip a little higher as the year progress. So Jeff, any closing thoughts?
Jeff Buchbinder: Yeah, one more point on earnings to close, John. Remember that the tax boost from 2018 comes out of the numbers in 2019. You alluded to this, John, when you said, "Tougher comparisons." So the cut in corporate tax rates added about 8% to earnings growth in 2018. That is not going to happen again so you basically take that out. So the slowdown might seem like a big slowdown in earnings in 2019 but it's really not as big as it seems because you take that corporate tax cut out as an anniversary. And by the way, there are other benefits to the tax cut and the whole tax reform package from December 2017 that are also not recurring in the same way. So some estimates suggest maybe 13 - 14 percentage points are coming out. Probably split the difference, maybe it's 10 - 12. But there's a lot coming out and it's just accounting so don't get to nervous about the slowdown.
John Lynch: Sure. Great point, thank you for bringing that up. And to close, it's always about earnings and income compounded annually to enable long term investors to achieve their investment goals. While, unfortunately, earnings and income compounded annually won't sell adverting space, it will help you achieve your long term goals. So I'd ask all our investors to please keep that in mind, all our listeners to keep that mind.
And Jeff, I want to thank you very much. And we'll look forward to being on the next Market Signals Podcast for LPL Financial over the next week or so. Thank you all so much, take care.