When news, both economic and political, is hitting the wire thick and fast, it is easy to become distracted. Every comment, every data point, and every report seem to take on exaggerated importance in a news-focused market, but in the long run, all those things only matter in one way: how they affect earnings.
Stocks represent fractional ownership of corporations, and that ownership increases and decreases in real value based on how much that corporation makes, or is expected to make, in any given period.
As earnings season draws to a close, it's worth taking time to analyze what the season has taught us.
To my mind, the best, most easily accessible data on that comes from FactSet, whose Earnings Insight series gives a weekly breakdown of the state of play during earnings season. For Q1 of 2019, that breakdown gives a clue as to why stocks are holding up as well as they are.
Yes, I know that we are coming off the longest weekly losing streak for the Dow since 2011, but the broader S&P 500 is off only around three percent from record highs.
Considering that President Trump is taking a big gamble by escalating a trade war with a major trading partner, and that Brexit is developing into a full-blown crisis, and that there are indicators such as an inverted yield curve suggesting trouble ahead for the U.S. economy, this isn’t bad at all:
The main reason is that 76% of S&P 500 companies that have reported so far have beaten consensus estimates. That is not quite as impressive as it sounds, given that over the last five years, an average of 72% of companies have achieved that, but better than average, nonetheless.
If anything, the surprise in that context is that we have dropped at all. You would expect that with over three-quarters of companies beating expectations, the market would be soaring. In part, the reason why that hasn’t happened is the gloomy news mentioned above, but there are also two other earnings related reasons: forward guidance and market sentiment.
Guidance from reporting firms has had a distinctly negative tone. That is not unusual. On average, over the last five years, a surprising 70% of S&P companies have issued negative guidance. This year, it is even higher, at 80%.
By the way, if you think there's a connection between the average of 70% of companies that temper expectations, and the 72% that beat expectations, you are not wrong. This is the “under-promise, over-deliver” game that CEOs constantly play with Wall Street.
The second, sentiment-based reason for stocks dropping despite the good earnings is illustrated by the market’s reaction to the beats and misses reported this earnings season.
The fact that positive reaction to beats has been less than average while the negative reaction to misses has been greater than average suggests that traders and investors are becoming more pessimistic.
That and the higher-than-average negative guidance are what should concern investors. They both make it much more likely that once the support engendered by EPS beats fades, we will continue lower. On the positive side, there was an air of negativity coming into this earnings season too, but the numbers show once again that U.S. companies can adjust and prosper whatever headwinds politicians generate.
All of this adds up to a situation where the short-term outlook is not good because of both sentiment and the likelihood of analysts revising their estimates down in response to negative guidance. That, and the continuing sensitivity to headlines make continued volatility look likely.
Longer-term, however, there is yet more evidence that companies can still make good money, even during a trade war, so, barring any black swan event, new highs are not that far away.
The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.
Martin Tillier
Martin Tillier spent years working in the Foreign Exchange market, which required an in-depth understanding of both the world’s markets and psychology and techniques of traders. In 2002, Martin left the markets, moved to the U.S., and opened a successful wine store, but the lure of the financial world proved too strong, leading Martin to join a major firm as financial advisor.
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