Over the last couple of quarters, it’s all been doom and gloom where earnings are concerned. Analysts with S&P Capital IQ warned at the beginning of the third quarter reporting season that Wall Street was expecting the first earnings decline since 2009, and they were right. However, the end results weren’t nearly as bad as was predicted at the beginning of October.
Calming investors’ fears
Now that the fourth quarter reporting season has begun, we’re hearing a similar story with Wall Street projecting an earnings decline of 5.88%, according to S&P Capital IQ, although that percentage is changing, virtually by the day. So was the fourth quarter as hard on companies as analysts are predicting? Morgan Stanley analysts think market sentiment is so low right now that investors will be pleasantly surprised.
In a report dated Jan. 12, analysts Adam S. Parker, Ph.D. and Brian T. Hayes, Ph.D. and their team said they think the fourth quarter reporting period will be a catalyst to calm the market’s concerns. They note that there haven’t been many negative preannouncements. Also U.S. consumers remain “relatively robust,” and there aren’t any major macro headwinds.
Same old pattern in earnings
Further, they said the earnings bar has been lowered, making it easier for companies to clear the bar. And because earnings expectations are so low, they expect to see “modest upside” to earnings results this time around.
So far, things are looking good, although we are still in the very early days. Alcoa’s earnings report on Monday marked the unofficial start of fourth quarter reporting season, but there were some other companies that reported before the aluminum maker. The Morgan Stanley team note that those early reporting companies generally beat estimates, although the sample size is still quite small.
But when pairing these very early earnings results with the lack of negative preannouncements, it becomes clear that most companies probably aren’t having problems meeting the expectations that were set in October. Also the macro issues pertaining to currency, oil and interest rates haven’t increased sequentially, and a warm December kept most consumers’ heating bills low while log gas prices also left more money in the average consumer’s pocket.
Consensus estimates cut in all sectors
Parker and team said that over the last three months, consensus estimates for fourth quarter earnings have been reduced in all ten sectors. Unsurprisingly, Energy and Materials remain the two worst sectors.
They added that when looking at individual companies, they’ve seen more than two instances of negative guidance for every one instance of positive guidance.
This indicates that the companies themselves have helped set the bar low for themselves. For the full year, consensus estimates suggest that earnings growth will remain essentially flat.
“The market is following the typical pattern of rewarding companies that beat consensus revenue and earnings while harshly punishing revenue and earnings misses,” the Morgan Stanley team wrote.
They highlighted that one important thing in the U.S. equity market that must be considered is companies’ expenses and whether they might make earnings estimates more volatile. They said that price action recently has raised fears that an “earnings recession” will arrive soon. However, they don’t think there will be a “meaningful earnings recession” even though investors seem to be expecting one.
Adjusting sector ratings
As the fourth quarter earnings season kicks into high gear, the Morgan Stanley team has adjusted their recommendations.
They downgraded the Technology sector from Market Weight to Underweight, cutting their exposure to the sector 3%. They have also cut their weight in Apple from 4% to 2% and exited their 1% position in LinkedIn while adding 1% to their position in Google parent company Alphabet.
They have also reduced their exposure to Energy 2%, leaving their exposure to the sector at 2%. They added 2% to their Utilities exposure and have also upgraded Industrials from Underweight to Market Weight. They also said that their upgrade of the sector isn’t a “broad affirmation” of the sector but simply an increase from 7% to 8% of the portfolio compared to the benchweight of 10%.
They like defense companies because of their growth compared to their shareholder returns and are adding 1% to their exposure to the Financials sector, which is still their largest Overweight sector. They remain at Market Weight on the Healthcare sector by adjusting some of their stakes and left their Consumer Discretionary weighting the same by adjusting some individual stock positions.
All graphs in this article are courtesy Morgan Stanley.