Earnings Provide Foundational Value

Originally posted at Briefing.com

The fourth quarter earnings reporting period isn't over yet, but it is moving into the late innings with 71% of the S&P 500 having already reported their results. The returns thus far have been pretty much as expected. What that means is that the results have been better than expected, yet they haven't been extraordinarily better than expected.

When it comes to earnings reporting, the final earnings per share growth rate is typically two to three percentage points above the estimated growth rate seen in front of the reporting period. Mindful of that, when the results end up two to three percentage points "better than expected," they are really in-line with expectations.

It's a parlor game of sorts, yet that important understanding partly explains why the S&P 500 has made a deliberate move, as opposed to a fast-track move, to all-time highs.

Closing the Loop

If something is in-line with expectations, it isn't surprising. For the stock market, that basically means it isn't market moving.

That's because the stock market is a forward-looking entity, so the in-line news has been priced in before it has happened. That is the essence of the market axiom that you "buy the rumor and sell the news," or, in some cases, you "sell the rumor and buy the news."

Outsized moves—both up and down—are reserved for genuine surprises. The move in Apple's (AAPL) stock following the company's report for the December quarter is a case in point.

It was a genuine surprise that Apple's iPhone sales topped expectations. That was a piece of good news that drove AAPL up 6.1% the day after the report. Conversely, it was a genuine surprise that Twitter's (TWTR) fourth-quarter revenue fell well short of expectations. That piece of bad news helped drive TWTR 12.3% lower the day of its report.

What we have learned from FactSet is that the blended earnings growth rate (actual results plus estimates for companies that have yet to report) for the S&P 500 for the fourth quarter is 5.0%. When we published our earnings preview on January 12, or just before the reporting period ramped up, the fourth quarter growth estimate was 2.6%.

Accordingly, there has been nothing extraordinary about the fourth quarter reporting period overall knowing that the blended earnings growth rate is currently just 2.4 percentage points above the downwardly revised growth estimate seen in front of the reporting period.

For what it's worth, the fourth quarter earnings growth estimate was 5.2% as of September 30, 2016, according to FactSet.

The fourth quarter reporting loop, then, has been closed for the most part, as results are tracking pretty much in-line with that September baseline, showing yet again how analysts lowered the estimate bar enough to provide an easy hurdle rate.

Something else that has been closed off with the fourth quarter reporting period is the earnings recession. The fourth quarter will mark the first time since the fourth quarter of 2014 and the first quarter of 2015 that earnings have increased on a year-over-year basis in two straight quarters.

Influential Support

In terms of the fourth quarter earnings growth, it has been driven predominately by two sectors. It just so happens that they are the two most heavily-weighted sectors—the information technology and financial sectors—so they have offered a good show of earnings support.

The information technology sector has contributed 2.29 percentage points to the fourth-quarter earnings growth rate while the financial sector has added 2.49 percentage points. The telecommunications sector has been the biggest drag, subtracting 1.21 percentage points, according to FactSet.

As seen in the table below, there have been only three sectors whose earnings growth rates have been negative year-over-year. That's an improvement from mid-January when it was thought five sectors would report a year-over-year decline in earnings.

SectorQ4 EPS Growth Estimate (as of Jan. 12)Q4 EPS Growth Estimate
(Current)
Consumer Discretionary-0.1%1.6%
Consumer Staples4.0%4.5%
Energy-7.4%-4.5%
Financials14.1%16.0%
Health Care3.7%5.3%
Industrials-7.6%-5.5%
Information Technology5.2%9.6%
Materials3.8%6.1%
Real Estate-7.2%6.6%
Telecom Services-27.8%-28.7%
Utilities14.8%19.5%
S&P 5002.6%5.0%

Source: FactSet

The Road Ahead

The earnings road ahead looks still to be paved with good intentions. The projected first quarter earnings growth rate currently stands at 9.9%. Let's call it 10.0%, which is down slightly from the 10.9% growth rate seen at the time of our fourth quarter earnings preview.

The implication in the first quarter forecast is that corporate guidance has been on the conservative side of things, yet it hasn't been dour by any means.

Many companies have made reference to the headwind posed by the stronger dollar and the uncertainty of not knowing when a cut in the corporate tax rate will be enacted. Nevertheless, the earnings guidance, in general, hasn't been a major source of contention for the stock market.

Mindful of that, market participants have been slow to sell out of positions as they continue to anticipate a better earnings growth picture down the road courtesy of deregulation, tax cuts, and infrastructure spending.

What It All Means

The deliberate advance of the stock market in recent weeks has been tied more than anything else to some underlying angst about corporate tax reform getting pushed out, as the Trump Administration have seem preoccupied with repealing the Affordable Care Act, instituting immigration control, and rebuking foreign countries (many of which are U.S. allies) for their unfair trade advantages.

Not surprisingly, the stock market responded quite favorably to President Trump's announcement in the past week that a "phenomenal" tax plan will be unveiled in the next two to three weeks.

There were no details accompanying that announcement, yet the mere mention of the idea served as an important reminder for the stock market that the administration hasn't taken its eye off the stock market's most important ball, which is implementing tax reform.

The fourth quarter earnings reporting and first quarter guidance may not have moved the needle much for the broader market, yet that's because there was a lot of good news priced into the market already and participants were contending with political issues more so than with earnings issues.

When political developments lean in the stock market's favor, however, there is a springboard of buying interest that ultimately rests on the earnings foundation.

That foundation is looking fairly solid, too—or at least as solid as it has for some time with double-digit growth rates still in the picture even without a cut in the corporate tax rate.

About the Author

Chief Market Analyst