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Don't Worry About Weak Third-Quarter Earnings: Nicholas Colas

Published 2017-10-18, 01:07 p/m
Updated 2017-10-19, 08:05 a/m
© Reuters.  Don't Worry About Weak Third-Quarter Earnings: Nicholas Colas

© Reuters. Don't Worry About Weak Third-Quarter Earnings: Nicholas Colas

(Bloomberg View) -- U.S. stocks enter third-quarter earnings season with a strong tailwind. The recent rally caps an already strong year for the S&P 500, which is up 14 percent. Volatility, as measured by the CBOE VIX Index, is at generational lows. There’s even been some healthy sector rotation that benefited laggards such as small caps and financials.

These trends would seem to indicate that markets believe corporate earnings reports will be just fine. After all, why bid up equity prices to 18 times forward earnings if you believe a raft of disappointing results are coming?

That's because investors expect the weakness to be a third-quarter blip, with earnings back on track by the fourth quarter.

But first here's the bad news. According to FactSet, analysts expect the companies of the S&P 500 to report third-quarter earnings growth of just 2.8 percent. That is a step function lower than the double-digit growth of the first half.

Of even greater concern: Expected revenue growth for the period is 4.9 percent, implying negative marginal profit contributions if earnings only advance by 2.8 percent. A large part of the good performance in the first half of 2017 came from better-than-expected operating margins. Now, the FactSet data show operating margins for the S&P 500 slipping from 10.4 percent to 10.2 percent for the third quarter.

A reversal of fortune on this point would spell trouble for the current market, which has a high valuation in part because of the revenue/profit leverage companies showed earlier this year. Even worse, analysts expect the margin declines to be broad-based, hitting eight of the 11 S&P sectors. Only technology, real estate and energy are expected to post positive margin comparisons.

So how do we pair a flashy market with dull earnings growth? The easiest answer is to assume companies will beat expectations, as they almost always do. By FactSet’s estimate, that would put earnings growth at 6 percent. Not bad, but hardly an explanation for the recent surge in equity prices.

Therefore, the best conclusion is that markets are simply looking through third-quarter earnings. Here are three reasons why:

First, hurricanes Harvey and Irma had a profound effect on the U.S. economy and corporate profits. Texas and Florida account for about $2.4 trillion in gross domestic product. That is about the same as the GDPs of the U.K. or France. Moreover, the two U.S. states are major hubs for industries such as energy and tourism.

We’ll have to wait and see which companies mention the storms as reasons for earnings misses. The economy is sufficiently intertwined that the second- and third-order effects will touch many areas. As long as managements have a reasonable explanation for how the hurricanes affected results, investors will likely give them a pass on a bad quarter.

Second, analysts expect the lull in earnings growth to be short-lived. They estimate an 11.1 percent earnings growth rate for the fourth quarter, and if companies beat their low third-quarter numbers those expectations may grow. Even better, expectations for earnings leverage are back to their levels of the first half, with forecast revenue growth of 5.7 percent.

In addition, consider that analysts also expect the S&P 500 to post double-digit gains in earnings next year, too. At the moment, they have an 11.4 percent growth rate penciled in for 2018, once again showing good earnings leverage from a 5 percent growth in revenue. Sectors they expect to do better than average include financials (14.2 percent growth) and technology (12.4 percent).

Finally, markets are looking beyond third-quarter earnings because there are enough other positive macro developments that support both valuations and those 2018 estimates. For example, while the Federal Reserve Open Market Committee may have three rate increases in its estimates for next year, Fed funds futures currently cluster around expectations of just one or none through September 2018. And while the European Central Bank should start curtailing its asset purchases next year, economic growth in the euro zone is steadily improving, a boon to large-cap public companies that do business there.

The upshot is clear: Investors are putting an asterisk next to third-quarter earnings. The recent storms will give a pass to many companies that disappoint. As long as companies hold their guidance for the fourth quarter, shareholders can look forward to a bounce in earnings growth and operating leverage in 90 days. And the macro backdrop points to still-low interest rates.

Yes, there is always a risk when markets think they have everything figured out. But absent a large exogenous shock to the system, the combination of low rates and a near- term bounce back in earnings should be enough to keep U.S. equities moving higher.

This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.

Nicholas Colas is the cofounder of DataTrek Research. He is the former chief market strategist at Convergex Group LLC.

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