Morgan Stanley’s (Eccentric) Equity Strategist Adam Parker looks at the world through a traditional value investors view point and wonders how markets are determining price levels. With nearly three quarters of the market capitalization reporting second quarter earnings, he notes the positive trends but then questions a key relative value point. His conclusion is in part seen in the headline of the August 1 report titled “Do Corporate Earnings Actually Matter?” (nothing to do with the Federal Reserve). This leads Parker and his team on a circuitous route to determine sector exposure recommendations.
Increasingly corporates are giving weaker forward guidance
Earnings have always been a key driver of stock market performance, typically keeping a lid on gains and a bottom on losses. The multiple by which investors can acquire a stock – the price earnings ratio – has always driven relative value analysis. While this formula is influenced by interest rates and forward economic guidance – driving the acceptable price earnings ratio both higher and lower – what Parker notices is a subtle correlation break with this reality.
“Amid a sea of macro concerns,” earnings are having a calming influence on stocks during the second quarter, Parker observes along with Morgan Stanley team members Brian Hayes, Antonio Orgeta and Chndrama Naha. The four analysts note stronger earnings but “mostly weaker forward guidance.”
Forward guidance being a key component of where a price earnings ratio finds fair value might be assumed as a catalyst for price discovery. But Parker, looking for key themes impacting how the stock market finds value – and what it means going forward – notes an oddity in the value equation.
Corporations are beating estimates — led by financials, technology and industrials
Major corporations have beaten consensus estimates by 5% thus far in the second quarter, with financials, technology and industrials leading the way. What’s behind the beat? The report notes negative earnings revisions heading into earnings season were disproven, “similar to what we have seen for the last 29 quarters with aggregate upside to expectations.”
While this is normally good news, Parker and his team, looking at market internals, notes the negative-to-positive guidance ratio is 1.69 for the third quarter of the year. What this means is that individual stocks are communicating nearly two instances of negative guidance versus one instance of positive guidance. More and more companies are setting their earnings bar lower and lower.
And yet the stock market continues to plow higher.
“This is a pretty strong performance with this many companies delivering (year over year) margin expansion despite the low overall revenue growth,” the report said. “The market appears to be differentiating on margins as stocks with margin expansion are being rewarded, and those with margin contraction are being punished.”
Morgan Stanley expects “modest” earnings growth, likes interest rate sensitive utilities and healthcare
Morgan Stanley’s top-down forward looking estimate is above consensus at $122.7 of earnings per share in 2016. This equates to nearly 4% operating earnings growth. Compare this to the bottom-up expectations of $118.43 in earnings and note an unusual difference in Morgan Stanley’s analysis.
“It is quite unusual for us to be above bottom-up estimates at this time of the calendar year,” the report observed. “While the wild cards to earnings from the macro standpoint include lower rates impacting financials, lower oil impacting energy, and a stronger dollar impacting a host of multinationals, our general sense is that earnings should modestly grow.”
For investors the key could be just how “modest” is modest?
That is difficult to determine. Earnings grew 6% excluding energy last year. Energy could actually be a boost to the balance sheet as Morgan Stanley thinks energy earnings will be higher in 2016 than in 2015. This should improve earnings.
Another traditionally positive factor is the S&P 500 should reduce the number of outstanding shares, on a net basis, by over 2% this year. This supply and demand influencing mechanism, which has been criticized in some quarters as losing its effectiveness, should boost stock values to come.
To recognize where opportunity may emerge is to recognize who might beat their earnings estimates:
At the sector level,2016 earnings growth expectations are highest in discretionary and health care and overwhelmingly lowest in energy. Consensus 2017 earnings growth expectations are at 14.0%, though we think it is too early to focus on what’s embedded in next year’s numbers given many analysts wait until early in the fall to sharpen their pencils on the out-year’s estimates.
Based on their analysis – and with difficult 2017 visibility in mind — Morgan Stanley recommends investors overweight utilities and health care — an interest rate play beside a beaten down sector. They also recommend underweight high-flying technology, defensive staples and materials — despite the potential for an infrastructure spend in the coming years.
There are, of course, variables that might impact this analysis. The “wild cards to earnings” come in the form of macro risk, which includes lower rates impacting financials, lower oil impacting energy, and a stronger dollar impacting a host of multinationals. Given this, Morgan Stanley’s view is “earnings should modestly grow.”