Record Third Quarter Earnings Expected; Energy Sector Main Driver

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It's here — again! We're talking about an earnings reporting period, which always commands a great deal of attention because earnings drive stock prices over the long term. To that end, the S&P 500 has been on cruise control for a while now, underpinned by impressive earnings growth.

The third quarter reporting period, which begins in earnest a week from today with reports from JPMorgan Chase (JPM), Citigroup (C), and Wells Fargo (WFC), should be no different. The earnings growth should be impressive, and the question is, will the guidance be the same?

There are some budding concerns that it may not be, which is why the third quarter reporting period — and the market's reaction to it — needs to be watched closely.

Room with a Third Quarter View

According to FactSet, the estimated third quarter earnings growth rate for the S&P 500 is 19.0 percent. Only the first and second quarter exceeded that growth estimate, which means S&P 500 companies are on track to print the third best quarter of earnings growth since the first quarter of 2011.

Analysts have been thinking as much, too, as the 1.1 percent decline in the bottom-up EPS estimate during the quarter is smaller than the five year, 10 year, and 15 year averages, according to FactSet.

Expectations have been tempered a bit then since the third quarter began, but they are still on the high side.

That hasn't been a problem for S&P 500 companies of late, which have hurdled high earnings growth expectations in previous quarters on the back of healthy revenue growth, lower tax rates, and share buyback activity.

Those factors should flow through again in the third quarter, with revenue growth expected to be up 7.0 percent and companies still getting the benefit of a reduced tax rate versus the year-ago period and ongoing share buyback activity.

The energy sector will be the main driver of overall revenue and EPS growth, though it will have plenty of company. There isn't a single sector that is projected to report a decline in EPS growth and FactSet informs us that seven out of 11 sectors are expected to report double-digit EPS growth.

Every sector is expected to report a year-over-year increase in revenue, too, ranging from 1.3 percent (utilities) to 16.5 percent (energy).

If things hold true to historical reporting form, it is highly likely that the third quarter will be the third straight quarter that S&P 500 earnings growth exceeds 20 percent as the final growth rate is typically two to three percentage points higher than the estimated growth rate at the start of the reporting period.

Rubbing Things the Right Way or the Wrong Way?

It won't be a surprise to hear of good earnings results in aggregate for the third quarter, but what might companies say about the fourth quarter and perhaps beyond with an early peak at FY19 projections?

That is the real rub of matters.

At this juncture, it is thought S&P 500 revenue growth and earnings growth will be 6.3 percent and 17.0 percent, respectively, in the fourth quarter.

Again, that's quite good, but one can see the sliding scale of growth estimates relative to the first quarter (25%), second quarter (25%), and third quarter (19% estimated). On a related note, FactSet shows an estimated growth rate of 7.1 percent for the first quarter of 2019.

In other words, earnings growth may not have peaked, yet it is expected to slow. That was the case, too, before the recent spike in interest rates, which is calling into question how much one is willing to pay for every dollar of earnings in a market that is already trading at a 15 percent premium to its 10 year historical average on a forward twelve-month P/E basis.

The earnings road ahead may not be hard exactly, but it will be less easy.

Tougher comparisons will arise as companies reach the anniversary of the cut in the corporate tax rate. Furthermore, a growing number of companies are citing higher costs of doing business that have been attributed to higher input costs, some of which have been blamed on tariff actions and increased wage costs.

Thus far, there haven't been many disappointments linked to tariffs. However as a larger basket of goods imported from China now faces an increased tariff, it will be interesting to hear if more companies start ringing tariff alarm bells when communicating their outlook.

What It All Means

The S&P 500 has experienced a great run, driven by a confluence of tailwinds including low interest rates, low inflation, and strong earnings growth that has been helped by easier comparisons given the cut in the corporate tax rate.

The uptick in earnings growth, though, has also been a byproduct of increased demand that has been an offshoot of a strong labor market and high levels of consumer and business confidence.

Those tailwinds continue to blow, yet some crosswinds are surfacing that hold the potential to slow those tailwinds:

  • The dollar is strong
  • Earnings comparisons are growing tougher
  • Tariffs have been implemented and the threat of further trade actions are out there
  • Interest rates are rising
  • Inflation is picking up because cost inputs and wages are increasing

In brief, the earnings backdrop has some challenges. They may not show up much in the third quarter reports, yet they could be heard more in the fourth quarter guidance.

If that is the case, the stock market may find itself moved more in the short term by earnings estimate revisions than actual earnings growth, which promises to be impressive — again.

About the Author

Chief Market Analyst