Via ConvergEx"s Nicholas Colas,
It’s great when a plan comes together.
The recipe for not just today’s rally but the whole move since Election Day is easy. Take one part new Administration with expansive plans to boost the US economy. Add in 2 measures of a Federal Reserve confident enough in existing macro growth to boost interest rates. Add a dollop of money flows.
Seems perfect, but there is one thing missing: the analysts who actually cover companies and make earnings forecasts aren’t buying it. Just look at the latest FactSet numbers – bottom up estimates for the S&P 500 have fallen this year from $133/share to $131.28 currently. In other words, the confidence that has taken stocks higher is obvious everywhere except for earnings expectations. One bright spot: our monthly look at analyst revenue expectations for the Dow stocks shows that Wall Street has (for now) stopped cutting their views on sales growth. Bottom line: US equities can only live on hope for so long.
Eventually, earnings estimates have to start rising in order to justify investor faith in faster economic growth. The big question is “When"?
I grew up in a household where no one really knew how to cook. My parents were Cuban immigrants, used to a life where other people cooked – at least until they came to US in 1960 with no money (let alone a household chef). The happiest culinary days of my youth were when my parents would go out for the evening and I got to have a TV dinner. Dinners for the rest of the month were my parents’ vague attempt at meatloaf (slimy), shake and bake chicken (far better as a meme from Talladega Nights), and chicken fried rice. At least I hope it was chicken – people in my neighborhood did keep pigeons. And not as pets.
As an adult I initially had no success in the kitchen, although one of the chief merits of living in New York is the ability to get by without ever having to turn on a stove. But takeout food is like dating – there is such a thing as too much convenience. To appreciate anything in life, you generally have to work at it. So I bought a set of pots and pans and some cookbooks and started to teach myself to cook.
Here is the biggest secret to good cooking: it has very little to do with cooking. In order to follow any recipe successfully (hard or simple, it matters not), the most important thing is to prepare. Read the ingredient list and prep everything first. Scan the instructions and put every item in the exact order you’ll need it. Visualize how it’s all going to work. Then, and only then, are you ready to start cooking. But if you do your “Mis en place” (the French term for getting your act together ahead of time), cooking even ambitious meals is actually pretty straightforward.
If all that sounds like an allegory for investing, it should. But only because cooking and investing are simply both parts of life. In general, the more you prepare the better off you are.
The recipe for the market rally since Election Day has its own ingredients, of course. Of course there’s the promise of faster economic growth from a new Administration. Add to that a little more optimism about global growth as well. Fold in still low interest rates and today’s Fed decision and Chair press conference (lots of optimism on display there) and you have the makings of a continued rally.
There is, however, one thing our “Mis en place” is missing: an improving outlook for corporate earnings. A few data points from the most recent FactSet Earnings Insight report (see here: https://insight.factset.com/hubfs/Resources/Research%20Desk/Earnings%20I...):
- Current bottom up estimates (those made by analysts that cover individual companies) for 2017 earnings for the S&P 500 are $131.28. In September of last year that number was $134.50 and on the eve of the US elections it was $133/share.
- That trend to lower earnings expectations is obviously counter to the general belief that earnings will improve as a result of the Trump economic agenda. The only trouble is that since that agenda hasn’t actually become law or policy, there is no way for Wall Street analysts to model it.
- In case you are wondering what analysts are looking for in 2018, the bottom up number there is $147/share (12% growth from the $131/share number for this year).
- The FactSet report has a very useful analysis of corporate earnings margins that highlights why the proposed reduction in corporate tax rates is both so enticing to investors and so important to market direction. Net margins are currently just as high as 2007, which is to say they are at peak levels (9.5% versus a 10 year average of 8.8%). Without a corporate tax cut, margins will likely decline in coming years either because wage and raw material inflation picks up or because the macro economy cools. (Page 17 of the FactSet report to see the graphs).
The key takeaway is that equity markets are discounting earnings streams that Wall Street analysts haven’t yet modeled (because the specifics are not yet known) or published. We are essentially flying blind. It is a very unique situation, something akin to when the Fed first launched quantitative easing. It all sounds great, but no one knows exactly how it will work.
If there is one piece of good news, it is that analysts seem to be pulling the reins on the near term pessimism that has been causing them to reduce earnings estimates for 2017. Every month we look at the revenue estimates that the Street publishes for the 30 companies of the Dow Jones Industrial Average. There are several charts below...
But here is a quick summary:
- For Q2 2017: back in mid-2016 analysts were showing expected revenue growth rates of +4% for next quarter. Since then they have reduced their estimates to 2.9%, but as of this month at least that number is holding (it was 2.9% last month as well).
- For Q3 2017: Analysts expect year over year revenue comparisons for the Dow companies to improve sequentially to 3.5%. As with the comp data for Q2, this month they have stuck to that number instead of cutting it further.
- For all of 2017: Analysts are only looking for an average of 3.4% revenue growth for the Dow companies. Yes, this was 4.5% last November so we’ve lost some ground on a fundamental basis even if stock markets have actually rallied.
The most important thing to take away from this quick 2-part analysis is this:
- The post-Election Day rally in US stocks is anchored in the belief US corporate earnings power will materially improve as a result of the Trump economic agenda.
- As of today, however, earnings estimates are still declining.
- The best thing you can say about the fundamental picture is that at least analysts aren’t cutting revenue numbers any more so perhaps earnings estimates will begin to improve soon.
- At some point, an equity market trading for +18x current year earnings is going to want to see either companies beat earnings estimates in resounding fashion or at least start to see analysts raising their earnings estimates. We aren’t getting the latter, and the former won’t happen until we get legislative action on taxes, infrastructure investment and deregulation.
In short, the current rally is very much a faith-based move. That’s OK. But at some point the sizzle becomes less important than seeing the steak. And if you don’t have all the right ingredients in place, it may not be much of a meal.
