Next Twelve Month EPS More Likely To Decline Near-Term
The S&P 500 has taken a breather since reaching a new all-time high on March 1st, with the index settling 1.5% below that high at the close on Wednesday. The pull-back comes just in time for the kick-off to the first-quarter earnings season. The early reporters have helped boost confidence in the 9.9% year-over-year earnings per share (EPS) growth projected by the consensus, though the market took its leg down as the majority of those companies released strong results. The political agenda likely weighed more heavily on the market over the same time period. EPS estimates have yet to reflect the market euphoria (S&P 500 has advanced more than 10% since election day) related to some potential policies that have driven the market higher.
The index is steadily emerging from the earnings recession that began in 2015 and ended three quarters ago. The recovery has been v-shaped with each quarter’s growth improving sequentially. The first-quarter of 2016 marked the bottom of the earnings recession as growth declined 6.7%. Given the easy growth comparison, the 9.9% projected for this quarter seems reasonable. Especially as economic data continued to improve, consumer confidence is at a high not seen since December 2000, wages are improving and energy is expected to become a tailwind for the index.
Given earnings season doesn’t really get started until the week of April 10th, it is likely the current 9.9% estimate will be revised lower ahead of the unofficial kick-off. Over the last five years, growth projections have been reduced by about 50 basis points on average in the two weeks ahead of earnings season as analysts and investors alike prefer for companies to beat the consensus estimate. Taking that into consideration, the official growth estimate at the start of first-quarter reporting period will likely be closer to 9.5%.
It is common for two-thirds of the index to beat the initial consensus estimate, which in the past has led to growth being 300 to 400 basis points better than the initial expectations on average. EPS growth hasn’t fallen short of expectations since first quarter 2009 and while fourth quarter 2016’s beat rate was below the average, the prior two quarters had solid beat rates (of 5.2% in Q3 2016 and 3.8% in Q2 2016). Companies like Micron Technology, PVH Corp., Lennar and Nike all had strong reports when they announced first-quarter results, highlighting the consumer as a key contributor in the quarter, along with technology companies that are expected to have the best growth in the index (after energy, see sector discussion below). Currently, 76% of the companies that have reported beat the consensus estimate, ahead of the 66% historic average. It is normal for that beat rate to decline as the earnings season unfolds. However, when all is said and done, first quarter growth could end being closer to 13% (using 9.5% as the base), which would be the best growth since 2011.
Forward Earnings Growth Sprout
Looking forward, the next twelve month (NTM) EPS of $129.78 marks a record high for the S&P 500 and represents growth of 10.3%. 2011 was the last time full year earnings growth exceeded 10%, a growth rate that is most often aligned with gross domestic product (GDP) growth higher than ~2%. The being said, second half earnings estimates have only been reduced slightly (58 basis points on average) since the start of the year and fourth-quarter growth of 13.0% seems a bit lofty. First half expectations have been reduced by 250 basis points on average over the same time period.
There has been much optimism baked into the market regarding the potential benefits from the Trump administration’s policies regarding tax reform, deregulation, and capital spending, but that same optimism has yet to be included in the consensus earnings estimates.
NTM EPS growth is now 150 basis points lower than it was on January 1, not higher as we would expect the case to be if the consensus was including benefits from policy changes. In any given year, growth typically ends 550 basis points lower than the estimate at the start of the year, with a significant amount of that reduction coming in the second half of the year. By that measure, NTM growth would end up being closer to 6% vs the 11.7% projection on January 1.
The year-to-date reduction in the NTM growth estimate is minimal compared to the prior two years, as seen in the chart below. 2015 and 2016, however, had to contend with weakening economic data, unseasonable winter weather and a West Coast port closure (in 2015). This year’s reduction is much more in-line with the trends of 2012-2014.
We believe estimates could break the trend of moving lower this year if tax reform and/or deregulation policy make their way through Congress, but we believe corporate management teams will refrain from providing guidance including any of those benefits until policies have been passed and details are known. Thus, it is unlikely that NTM estimates will move higher any time soon.
As estimates move lower and the stock market stabilizes only 1.5% below recent highs, valuation has been maintained at a premium. Trading at 18.2x on a NTM price-to-earnings basis, the S&P 500 is more than 2x richer than the historic average. Our concern is that the earnings estimates move lower, and not higher near-term, which could be a challenge for the market during the seasonally soft summer months (frequently referred to as the “Sell in May” period).
Q1 EPS Growth by Sectors
Digging into first-quarter earnings growth, the largest change will be the energy sector turning from a headwind over the last two years to a tailwind. The consensus estimate is for energy EPS of $3.02, much better than the loss of $0.35 last year. After energy, information technology, financials, and materials, will lead with double-digit growth. It will be the third quarter in a row that the financials and information technology are included in the top three growth sectors. Real estate, consumer staples, and health care have growth rates ranging from flat to 6%.
Declines are projected from industrials (-5.7%), consumer discretionary (-4.0%), telecommunication services (-2.3%) and utilities (-1.8%). The last time the consumer discretionary group posted a decline in profits was the first quarter of 2009.
The 9.9% growth rate is the best the index has recorded since 2011, and is above the average growth of about 8% per quarter characteristic of the index prior to the earnings recession.
On the top line, growth continues to improve from the previous quarters. Analysts are currently modeling a 7.2% increase in revenue growth, with financials, energy, telecommunications and industrials leading. Interestingly, materials revenue growth is projected to decline 4.2%, the second worst growth in the index, even as earnings growth is expected be the fourth best. That likely is related to commodity price volatility, similar to the decline