(Earnings) Season’s Greetings

By the numbers, Q3 earnings season looks solid. By the headlines, not so much. Coverage hypes “peak earnings” and argues stocks can’t rise absent new “catalysts.” In our view, all this negativity merely reflects dour sentiment, typical during corrections. While backward-looking, Q3 earnings—and the media’s reaction to them—indicate fundamentals are still sunnier than most appreciate.

With 74% of S&P 500 firms reporting through November 2, FactSet data show Q3 earnings are on pace to rise 24.9% y/y, with 78% of firms beating expectations.^[i] If this pace persists, Q3 would be the third straight quarter of 20%+ earnings growth.^[ii] Revenues aren’t missing the party—they are up a solid 8.5% y/y thus far, with 61% of firms beating.^[iii] All 11 sectors reported rising earnings and revenues—and 9 reported double-digit earnings growth.^[iv] With an assist from recent volatility, higher earnings have pushed the S&P 500 forward price-to-earnings ratio down from 18.5 on January 26—the date the S&P 500 peaked before this winter’s correction—to 15.6 on November 2.^[v] Given the prevalence of “valuations are too high” fears last year, one might have expected media to breathe a sigh of relief. But instead, the spotlight turned to new worries, like “peak earnings”—the notion companies are struggling to maintain profit growth now that the alleged tax cut sugar high has worn off.

True, expectations for Q4 earnings and revenue growth are lower—15.0% and 6.8% y/y, respectively—than Q3.^[vi] But tax cuts have precious little to do with revenue, which has risen nicely this year. Besides, the idea corporate tax cuts gave some firms a one-time earnings boost isn’t sneaking up on markets. Forward-looking stocks knew all along the jolt was likely to skew earnings growth for a spell, then fade. Heck, headlines have been warning of this moment since before the tax bill crossed President Trump’s desk last December. To efficient markets, this is ancient history.

The terminology is also scarier than reality warrants. To those not well-versed in the niceties of shifting rates of change versus fluctuations in an absolute level, the phrase “peak earnings” might sound like earnings are poised to decline. As climbers know, after you reach the peak, you descend. But this isn’t the sort of peak earnings are allegedly summiting. Even pessimists are forecasting decelerating earnings growth—which is still growth. Slightly slowing growth from a very fast rate is no cause for alarm, in our view.

Moreover, the last earnings growth “peak” was Q3 2010—early in this long bull market and a phenomenal time to buy stocks. This is clear evidence stocks don’t need the “catalyst” of accelerating earnings growth—that is, company earnings increasing at an ever faster rate—to rise. Keep in mind also that today’s fears center around earnings growth (potentially) slipping from ~25% in Q3 to ~15% in Q4. But in the so-called “earnings recession” of Q2 2015 – Q3 2016, Energy sector woes flipped earnings growth negative. Yet stocks rose 8.3% during that span, and the bull market continued.^[vii]

Still others point to the fact companies beating Q3 earnings estimates have risen an average of just 0.2% from two days before their earnings release through the second day after—well below the 1.0% historical average bump for a beat.^[viii] Some claim this means earnings beats don’t impress investors anymore—leaving them powerless to “catalyze” rising stocks. As one recent article put it, “It used to be that however glum stock traders got, earnings season would arrive and cheer them up. That it hasn’t happened this time around is a big source of the current anxiety.”^[ix]

We see this as so much statistical noise. Individual stock price movement across four days—not even a full workweek—has no relevance for long-term investors. And while pinning down causes for day-to-day price wiggles can be a wild goose chase, it seems likely the subpar performance of companies beating Q3 earnings estimates related to the ongoing stock market correction. Sharp, sentiment-driven market declines can encompass firms beating earnings estimates, too. And just as corrections can strike for any or no reason, they can go away without a fundamental “catalyst” riding to the rescue. Those waiting for one—or pining for those supposedly past—can likely find plenty of excuses to stay out of stocks while the bull market powers on.

This doesn’t mean Q3’s solid earnings growth isn’t bullish per se. Yes, it is long since priced in. But its lukewarm reception offers a glimpse at sentiment—still jittery after recent volatility and skeptical about whether good times will persist. Missing positive fundamentals—or fretting they’ll end soon—are classic correction traits. We believe this gap between reality and expectations should help buoy stocks over the foreseeable future.