Earnings Breather Not a Bear Harbinger

Story Highlights:

• So far S&P 500 earnings have been weak, but excluding a few industries, earnings are growing nicely.
• A slowing rate of growth is often not a sign of a coming recession or bear market—it can be a sign of an economy that's been consistently strong.
• Extremely dour expectations are already reflected in stock prices and likely to be surpassed looking ahead—a bullish signal.

With a little over 125 companies reporting, year-over-year earnings growth for US corporations looks about flat for the 3rd quarter. As of 10/19, the quarter's best performers (in terms of earnings growth) were healthcare (13%) and technology (11%); and the worst were financials (-11%) and consumer discretionary (-10%).

Financials in particular are facing struggles this quarter tied to asset write downs. Merrill Lynch's reported earnings today are a prime example. The company took a $7.9 billion hit due primarily to a write down in portfolio assets tied to mortgage-related debt securities.

Merrill Lynch Posts Loss on $7.9 Billion Write Down
By Tim McLaughlin, International Business Times
https://www.ibtimes.com/articles/20071024/merrill-lynch-earnings.htm

Thusly, folks might conclude this evidences a very weak economy. We'd note US corporate growth is actually widespread when excluding a few industries (homebuilders, diversified financials, investment banks and brokerages). Without these, earnings growth would be around 4%.

In the eyes of many, this opening batch of reports portends the first YOY quarterly earnings decline since Q1 2001—a situation last seen during the last recession and bear market. Earnings growth in Q3 will be modest to be sure—but because a big chunk of the biggest underperformers (financials) have already reported, from here we expect earnings to come in materially better than what we've seen so far.

Our suspicion is even in the afflicted industries growth is merely taking a breather. When thinking about the direction of stock markets, it's important to think about the economy in a holistic way—the sum of the parts. Fretting individual parts is often the wrong path. Yes, residential housing, financials and consumer discretionary companies are performing poorly today; but commercial real estate and US exporters are having a banner year, nearly offsetting that weakness while the rest of the economy experiences solid growth.

But, isn't slowing or flat earnings growth a sign recession is near?

Not at all. This isn't the first time earnings growth has slowed amid the current expansion. It's natural for an economy that's been robust for some time to show "slowing" growth. This is a perspective problem—most economic data is reported on a "year-over-year" basis—meaning quarterly and annual numbers are compared to the same period a year ago. Coming off a recession, it's easy for an economy to beat weak growth numbers. But after years of strength, it gets tougher to significantly beat already strong results. The US economy has been strong going on five years—it's perfectly natural it won't top itself with the same magnitude as when recovering from the weakness of 2000 and 2001.

Thus, a recovering economy will nearly always show better YOY growth than one that's been humming along for some time. But the vital fact to remember is this is a statistical quirk, not a sign of a coming recession.

What matters for stock performance relative to earnings is beating expectations as well as the absolute level of growth. Extremely dour expectations are priced into stocks today. Given the strength of the global economy and the magnitude of share buybacks—along with a host of other factors including still growing productivity, benign interest rates and growing personal income—our guess is earnings will continue to outpace expectations in the coming quarters. Such positive surprises are very bullish. And we find it highly unlikely results will be worse than current pessimistic forecasts.

Lastly, always look to the world and not just America. MarketMinder says this often, but here it's as true as ever. The US accounts for less than 40% of the world's economy. That means the majority of the world economy is non-US. Non-US economies are on solid ground today, with highly positive fundamentals looking forward.

Make sure to see the whole, not just the parts when thinking about market direction. Doing so shows a world economy still growing and great values to be had in stock markets.

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Source: Thomson One Analytics