Now that the third quarter of 2018 is done, traders and investors will be turning their thoughts to the upcoming earnings season. There is bound to be some volatility based on other factors in the meantime; the ongoing trade saga will result in a pop this morning, for example, but the long-term direction of stocks will ultimately be decided by how corporations are faring.
Those headline-driven moves can, as we have seen recently, reverse quickly, but profit levels are the foundations on which trends are built.
History suggests that earnings season will be supportive of stocks. Expectations for corporate profit and revenues are priced into stocks to some extent, so what moves prices are deviations from those expectations, and beats are common.
In fact, they are more than common, they are the norm. On average, around two thirds of companies listed in the S&P 500 beat expectations every quarter. This time, however, could be different.
Last quarter’s earnings were particularly strong, both in real terms and relative to estimates. Around eighty percent of S&P 500 companies declared higher profits than Wall Street analysts anticipated in Q2, the highest level in years. As a result, it has been a strong quarter for the major indices, but it has also set a high bar to be cleared this quarter.
Traders are aware that one swallow doth not a summer make, but if we assume that last quarter’s stellar results were at least in part due to tax cuts and deregulation it is only natural to go into this earnings season expecting more of the same.
There are, however, some potential issues. Firstly, there have been some real changes to business conditions this last three months. So far there has been no real indication that the tariffs imposed in the trade wars have had any real negative effect on earnings or economic data, but at some point, they must.
The lack of inflationary push suggests that many companies are absorbing the cost increases that tariffs cause, presumably in the belief that the disruption will be temporary. This morning’s news that Canada is set to join Mexico and the U.S. in a re-work of NAFTA would suggest that that is a fair assumption, but the attempt to keep prices steady in the face of import and export taxes will probably result in reduced margins, and therefore profit.
The second factor that could weigh is more a matter of guesswork than data. Most analysts agree that the rate of earnings growth will begin to slow in the first quarter of next year, so some relatively weak guidance can be expected as companies report. That tendency is likely to be exaggerated as management teams asses the potential impact of higher interest rates now that the Fed is no longer being “accommodative.”
We could, therefore be setting up for a situation where the “normal” two-thirds of reports beating expectations is a disappointment. The focus would shift to forward guidance should that be the case, and it is hard to see how that can be a positive. Again, even reasonably upbeat forecasts would be a downgrade on recent quarters, and in the stock market, expectations matter.
That is why it will behoove investors to start looking for clues this week from off-season earnings and monthly data.
The first of those will come tomorrow, when PepsiCo (PEP) and Paychex (PAYX) report for their most recent quarters. PepsiCo has had some company specific issues but will provide a snapshot of global markets (an analysis of what to expect from their report can be found in this Richard Saintvilus piece), while Paychex have a good handle on the expansion and hiring plans of U.S. businesses.
The big data to watch will come this Friday, when the Bureau of Labor Statistics release the September jobs report.
All in all, this is a “wait and see” week. The NAFTA agreement and the possibility it raises of a resolution to trade issues elsewhere will give support, but the risk will come from early earnings and data. Bear in mind that in the current optimistic environment, matching published expectations in those cases will probably not be neutral. Any disappointment will cause a sharp downturn, but the danger really comes from so-so numbers that bring the outlook for this earnings season back down to Earth.