Peak Optimism?

With 467 of the 500 companies in the S&P 500 already reporting first-quarter results, we can now get a good picture of corporate performance for the period. According to Bloomberg, S&P 500 earnings-per-share grew at a 23.6% pace and revenue grew at a 8.1% pace in the first quarter of 2018. These results, while obviously boosted by the passage of the Tax Cuts and Jobs Act (TCJA), are very strong relative to historical averages. Perhaps even more encouraging, though, is the magnitude of the upside surprise relative to analysts’ expectations. S&P 500 companies exceeded analysts’ earnings estimates by an average of 6.9% in the quarter, with each of the eleven industry sectors coming in ahead of expectations. Revenue also beat expectations (but by a much smaller 1.1%), while just 2 of eleven industry sectors failed to beat revenue expectations (Energy and Telecom). If we didn’t know better, we’d say the economy must be firing on all cylinders!

Source: Bloomberg

Source: Bloomberg

While nobody disputes the strength of 1Q earnings, there are two questions of utmost importance to investors going forward: 1) how much of the 1Q beat was already incorporated into stock prices? and 2) have analysts now become too optimistic in their estimates for the rest of the year and beyond?

Our view is that current stock prices and analysts’ estimates reflect a significant amount of optimism for both the balance of 2018 and 2019. While the growth rate in earnings for 2018 reflects the benefits of the TCJA, the average estimate now calls for nearly 21% earnings-per-share growth. Growth like this is clearly possible as evidenced by 1Q results. But from that lofty base for 2018, analysts also currently expect another 10% growth in earnings-per-share in 2019. If these targets are hit, S&P 500 earnings-per-share will be 33% higher in 2019 as compared to 2017 levels. Sure seems like we’d need some significantly better economic growth in order to put up results like that. This is especially true given the current high level of corporate profit margins.

Our May 10th Market Commentary described the multiple headwinds that are emerging as companies look into the future. We suggested that companies would be facing rising labor costs, rising debt-service costs (higher interest rates), rising commodity costs (particularly energy), a rising dollar, and increased investment spending (a portion of which is expensed rather than amortized). There are a couple of other factors that should be given due consideration as well. First, what is the probability that trade wars could put a dent in corporate earnings? Clearly we need to assign some probability that trade actions, whatever they may be, could negatively affect the ability of US multinational companies to compete in the world markets. Trade wars could also lead to rising consumer prices, which would be a drag on economic growth. And secondly, how much of the tax-cut benefits from the TCJA will get “competed away” as individual companies attempt to wrest market share from the competition? These are potential headwinds that we think may be underappreciated as the analyst community calls for 33% earnings growth in the S&P 500 from 2017 to 2019.

Indeed, there is scant evidence at present that companies are nervous about the challenge. While there were individual companies that warned of lower-than-expected sales or earnings (or both) for the balance of 2018, the earnings guidance from management teams remains, by and large, constructive. With regard to 2019, very few management teams have provided explicit guidance at this point. Much could happen between now and then, but at this point we would suggest that the likelihood of disappointment is unusually high. As such, we continue to believe that the onus is on companies to show that they are able to hit lofty growth expectations. If not, and earnings estimate need to be reduced, there could be some volatility ahead.