In brief
Markets have bounced back nicely in 2019 after a volatile December, but this bounce has been driven almost entirely by multiple expansion. Earnings revisions have moved sharply lower, causing 1Q19 estimates to fall into negative territory. That said, estimates have likely fallen too far. The financial and healthcare sectors are expected to see positive earnings growth, while globally exposed sectors should struggle due to slower global growth and a stronger dollar. Meanwhile, lower oil prices compared to a year ago should weigh on energy sector profits. With effective tax rates now similar on a year-over-year basis, margins are no longer getting the artificial boost they did in 2018, and are expected to contract year-over-year due to rising wages and input costs. We prefer large cap over small cap, and cyclical value sectors that provide income and a more balanced total return profile. The round-trip flight
The S&P 500 has risen 15.9% so far this year, putting the index on pace to return 70.1% in 2019. While solid returns to start the year were expected given the sell-off in December, trees do not grow to the sky, and it seems unlikely that this annualized return will be achieved. Furthermore, despite the fact that the Federal Reserve has paused its interest rate hiking campaign, better data out of China (in the form of the March PMIs) suggests that global growth may accelerate in the coming months, allowing long-term interest rates to move higher. If this is the case, it will limit the extent to which multiples can rise.The reason why this is important is highlighted in
Exhibit 1, which decomposes the S&P 500’s return from the end of 3Q18 through the end of 1Q19 into earnings growth, multiple expansion and dividends. Valuations led the market lower in December, and then rebounded back to average levels earlier this year as concerns over the trajectory of global growth have begun to fade.
Cumulative total return since 9/30/18 broken into earnings, multiples and dividends
However, the extreme pessimism that took over markets at the end of last year was not entirely unwarranted, as U.S. economic growth was softening at a time when growth in the rest of the world was already subpar. This dynamic led earnings estimates to move lower over the course of the first quarter; not only have these revisions been negative and broad-based, but also there has been a clear downward trend in corporate guidance during the past few months.While any extended period of negative earnings growth would pose a threat to the current expansion, declining earnings estimates can actually help the stock market move higher, as lowering expectations makes beating those expectations that much easier.At the current juncture it seems like earnings estimates may have declined too far, and while consensus is looking for negative earnings growth from a year prior, our view is not quite as downbeat. That said, earnings will be key in determining where we go from here. Lingering uncertainty around the trajectory of policy and growth will weigh on multiples over the long run, even if a temporary pause at the Fed allows them to move higher in the near term. As such, any sustainable upside in markets from current levels will need to be driven by earnings, which look set to grow between 3% and 5% for 2019 as a whole.The earnings party takes a pause One characteristic of the current earnings season has been the unrelenting downward bias to estimates and guidance over the past few weeks. 1Q19 revisions have moved sharply lower since the beginning of the year...
