It's Complicated

 

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The stock market continues to be volatile due to an overvalued stock market, indexes rising due to the influence of momentous stocks, geopolitical concerns, global market concerns and the trade war.  The major effects of the tax cut passed by Congress will end at the end of 2018 as far as earnings growth goes.

The Stock Market (from the FACTSET “Earnings Insight July 27, 2018”)

Key Metrics

  • Earnings Scorecard: For Q2 2018 (with 53% of the companies in the S&P 500 reporting actual results for the quarter), 83% of S&P 500 companies have reported a positive EPS surprise and 77% have reported a positive sales surprise. If 83% is the final number, it will mark the highest percentage since FactSet began tracking this metric in Q3 2008.
  • Earnings Growth: For Q2 2018, the blended earnings growth rate for the S&P 500 is 21.3%. If 21.3% is the actual growth rate for the quarter, it will mark the second highest earnings growth since Q3 2010 (34.1%).
  • Earnings Revisions: On June 30, the estimated earnings growth rate for Q2 2018 was 20.0%. Nine sectors have higher growth rates today (compared to June 30) due to upward estimate revisions and positive earnings surprises.
  • Earnings Guidance: For Q3 2018, 29 S&P 500 companies have issued negative EPS guidance and 14 S&P 500 companies have issued positive EPS guidance.
  • Valuation: The forward 12-month P/E ratio for the S&P 500 is 16.7. This P/E ratio is above the 5-year average (16.2) and above the 10-year average (14.4).

Looking Ahead: Forward Estimates and Valuation

Earnings Guidance: Negative EPS Guidance For Q3 2018 is Below Average

The term “guidance” (or “preannouncement”) is defined as a projection or estimate for EPS provided by a company in advance of the company reporting actual results. Guidance is classified as negative if the estimate (or mid-point of a range estimates) provided by a company is lower than the mean EPS estimate the day before the guidance was issued. Guidance is classified as positive if the estimate (or mid-point of a range of estimates) provided by the company is higher than the mean EPS estimate the day before the guidance was issued.

At this point in time, 43 companies in the index have issued EPS guidance for Q3 2018. Of these 43 companies, 29 have issued negative EPS guidance and 14 has issued positive EPS guidance. The percentage of companies issuing negative EPS guidance is 67% (29 out of 43), which is below the 5-year average of 72%.

Near 20% Earnings Growth Expected For 2018, But Lower Growth Projected for Early 2019

For the second quarter, companies reporting earnings growth of 21.3% and revenue growth of 9.3%. Analysts currently expect earnings to grow near 20% for the remainder 2018, but also expect more moderate growth for early 2019.

For Q3 2018, analysts are projecting earnings growth of 21.2% and revenue growth of 7.7%.

For Q4 2018, analysts are projecting earnings growth of 18.0% and revenue growth of 6.0%.

For Q1 2019, analysts are projecting earnings growth of 7.3% and revenue growth of 5.8%.

For Q2 2019, analysts are projecting earnings growth of 10.2% and revenue growth of 4.8%.

Valuation: Forward P/E Ratio is 16.7, above the 10-Year Average (14.4)

The forward 12-month P/E ratio is 16.7. This P/E ratio is above the 5-year average of 16.2, and above the 10-year average of 14.4. It is also above the forward 12-month P/E ratio of 16.1 recorded at the start of the third quarter (June 30). Since the start of the third quarter, the price of the index has increased by 4.4%, while the forward 12-month EPS estimate has increased by 1.0%.

At the sector level, the Consumer Discretionary (21.2) and Information Technology (19.0) sectors have the highest forward 12-month P/E ratios, while the Telecom Services (9.8) and Financials (12.7) sectors have the lowest forward 12-month P/E ratios. Eight sectors have forward 12-month P/E ratios that are above their 10-year averages, led by the Information Technology (19.0 vs. 14.5) and Consumer Discretionary (21.2 vs. 16.9) sectors. Two sectors have forward 12-month P/E ratios that are below their 10-year averages, led by the Telecom Services (9.8 vs. 14.0) sector.

Targets & Ratings: Analysts Project 10% Increase in Price Over Next 12 Months

The bottom-up target price for the S&P 500 is 3123.49, which is 10.1% above the closing price of 2837.44. At the sector level, the Materials (+14.3%) and Telecom Service (+13.7%) sectors are expected to see the largest price increases, as these sectors have the largest upside differences between the bottom-up target price and the closing price. On the other hand, the Utilities (+3.3%) sector is expected to see the smallest price increase, as this sector has the smallest upside difference between the bottom-up target price and the closing price.

Overall, there are 10,905 ratings on stocks in the S&P 500. Of these 10,905 ratings, 53.0% are Buy ratings, 41.6% are Hold ratings, and 5.4% are Sell ratings. At the sector level, the Information Technology (59%), Health Care (59%), Energy (58%), and Materials (58%) sectors have the highest percentages of Buy ratings, while the Telecom Services (41%) sector has the lowest percentage of Buy ratings.

Price/Earnings Ratios (P/E Ratios)

On July 31, 2018 the P/E Ratios of the key indexes were as follows:

        Dow Jones Industrial Average

             23.06x Trailing 12 months, 16.59x Forward

        S&P 500 Index

             24.13x Trailing 12 months, 17.65x Forward

        NASDAQ Composite Index

             26.11x Trailing 12 months, 21.43x Forward

The trailing numbers are very high versus historic P/E Ratios.  The Forward estimates are high compared to Historic Forward estimates.  With the stock market overvalued waiting for the earnings growth numbers to come in there are those that may get nervous and may take profits as we get closer to year end.  We will watch this closely.

Value Versus Growth

In the Performance Executive Summary in the Market Data section you will find a chart entitled “Value Versus Growth”.  It shows that about half of the time Value stocks outperform Growth stocks, and the other half Growth outperforms Value.  In 2017 and the first half of 2018 Growth outperformed Value.  In the latest year ending June 30, 2018 the Russell 1000 Growth index returned 22.5% while the Russell 1000 Value Index returned 6.8%.  In the second quarter Growth was up 5.8% and Value only 1.2%.  The Growth Index has been lead by its largest holdings: Apple, Microsoft, Amazon, Facebook and Alphabet (Google).  Information technology makes up 41.5% of the index.  The Value Index’s largest holdings are JP Morgan, Exxon, Berkshire Hathaway, Johnson & Johnson, and Bank of America.  As the chart shows, at some point Value will start outperforming Growth.

This is why we split the small cap and large cap stock allocations 50%-50% between Growth and Value.  As investors get worried do not be surprised that money moves from growth stocks to value stocks that are less expensive.

The Fed and Interest Rates

You will see in the Market Data section of the Performance Executive Summary a table that documents the dates and results of historic Federal Reserve Rate Hikes.  If the Fed continues to raise short-term rates and the Yield Curve flattens or inverts, the odds are we will have a recession.  As the Fed has raised rates the long end of the curve has remained relatively stable because of large investors from around the world, where rates are lower than the US, are buying Treasuries.  The projection is that the Fed will raise rates two more times this year.  The current federal funds rate is 2.0%.  The Fed has signaled that it will raise rates to 2.5% in 2018, 3.0% in 2019 and 3.5% in 2020.

Inflation

Inflation is not an issue at this point and according to Hoisington Investment Management will not be in the foreseeable future. (See Market Data)

International Stocks Versus US Stocks

The international equity market is less expensive based on forward P/E Ratios of the S&P 500 and the MSCI All County World Index. (See Market Data)  Therefore, the international market is more attractive at this time than the US market based on this measure.

Gross Domestic Product (GDP)

GDP was running at a 4.1% rate in the second quarter.  It is projected to slow down going forward.  (See Hoisington)

Energy

Oil is expected to rise in price because production over the next one to two years is expected to fall.  Production in Venezuela, Mexico and Iran is expected to fall.  Venezuela and Mexico have not invested in oil infrastructure and their fields are suffering.  We know that the US sanctions on Iran are pointed at lowering its revenues from the sale of oil.  The Permian Basin in Texas could make up the difference, but currently there are not enough pipelines to get the oil out.  Pipelines are being built but it will take time to do.  Oil and oil services stocks are expected to do well as a result.

Emerging Markets

Emerging markets are suffering due to the stronger dollar.  Countries with dollar denominated debt have to pay more when the dollar is strong.

China and the Trade War

China GDP has been slowing.  The Trade War is affecting its economy and is affecting US stocks in industries that are vulnerable.

Hoisington

We have included the entire Hoisington Investment Management Company “Quarterly Review and Outlook Second Quarter 2018”. Although it is somewhat technical, you should find it enlightening and interesting.  You can begin to understand the underlying dynamics that affect the global economy and why we must not assume that this long rally in the stock market since March 2009 will continue indefinitely and why interest rates and inflation are not something to worry about at this point.

Conclusion

What does all this mean?  In the near term, we do not expect much to change.  As we get closer to the end of 2018, we will be watching institutional investors to see if and when they start taking profits and if money moves from growth stocks to value stocks.  We will be watching the yield curve.  If the Fed continues to raise short-term rates to a level that flattens or inverts the curve, we will be recommending a reduction in equity allocation.  We will monitor what Hoisington points out about debt and GDP.  Earnings growth is a key factor in the stock market.  The consensus is that growth will slow after 2018.  This should affect P/E ratios and could cause a correction by itself.  The US stock indexes have risen because of the large influence of a few stocks like the FANGs, and a move to indexing including ETFs.  As a result, many weak companies with poor balance sheets and poor earnings growth have risen in price because they are in the indexes.  This will reverse at some point like all fads have in the past.

 

Jamison Monroe
Chairman & CEO
Director of Consulting