Wall Street indexes may have touched the record highs on Wednesday, but only after two weeks will start the second quarter earnings season, which poses a threat for the markets.
Analysts took a pessimistic view of profits in the second quarter. They are now predicting a decline in the first three quarters of 2019 and the companies respond to these concerns with pessimism, which is not usual for corporate America.
On the eve of the reporting season, which begins not on July 15, 87 (77%) of the 113 companies that announced expectations of their profits warned that their net result would be worse than the analysts’ estimates. This is above the usual level of 79 companies (70%) that traditionally declare negative expectations and the second worst since FactSet began to keep statistics in 2006. The record of 92 negative expectations was set in the first quarter of 2016
At a time when the Dow Jones index achieved its best June since 1938, the hesitant picture of earnings does not contribute to the confidence that this upsurge may continue.
The profits of the S&P 500 companies, which had their strongest June since 1955, are projected to fall by 2.6% compared to the second quarter of 2018.
The raw reality is that data will affect investors’ mood and this cannot be ignored. Although the markets are on historic highs, the economy is definitely slowing down.
The profit issue is complicated, but it is mostly linked to customs and weakening global growth.
In terms of industries, the most negative expectations for profits are for information technology and health care, which are at the center of the customs battle between the US and their global trading partners, especially China.
The technologies were in the core of the duties imposed by President Donald Trump on Chinese imports with an annual turnover of 250 billion USD.
At the same time, duties on steel and aluminum hit directly in the healthcare industry, affecting medical imports of 1.8 billion USD. The total effect of customs duties will cost the industry about 400 million USD, according to the American Action Forum. In addition to the duties, the health sector faces a serious regulatory risk, with leaders of both Congress parties wanting to limit the amounts that pharmaceutical companies may want for their medicines.
The international companies as a whole suffer mostly from the duties. FactSet estimates that companies that account for more than half of their sales outside the US expect a 9% decline in profits in the second quarter.
An important factor that supports the market is that, even at a slower pace, the US growth is stronger than in the rest of the world. However, the accumulation of problems can further push investors to asset havens such as bonds and gold that have benefited from US-China trade tensions.
Decline in corporate profits is not necessarily bad for Wall Street
The fears of a decline in corporate profits may be overexposed, as the stock market is performing better when profits are declining. This is because such times increase the likelihood that the Federal Reserve will lower interest rates, and investors love lower interest rates more than they hate reduced profits, as long as they do not, of course, collapse dramatically.
The last few quarters are an example. In the fourth quarter of 2018, when earnings grew tangible, the S&P 500 fell by 14%. In the first quarter of 2019, when earnings declined on an annual basis, the S&P 500 rose 13%. In the second quarter, when profits are expected to have fallen by 2.6%, the S&P 500 added another 3.8%.
The last few quarters are not an isolated case, according to Ned Davis Research. The analysts find that since 1927 the stock market has performed best in those quarters in which the profits of S&P 500 companies drop by between 10% and 25% on an annual basis. In these quarters, the average annual growth rate of the index was 25%.
When profit growth was more than 20% on an annual basis, the S&P 500 achieved an average annual growth of 2.6%. Only when the quarterly profits dropped more than 25% on an annual basis, the stock also declined on average.
If it is difficult to accept these results, look at another study that takes a completely different approach to arrive at the same conclusions. This study was made a year ago by Vincent Deluard, head of global macro strategies at the financial services firm INTL FCStone.
Vincent Deluard held the following thought experiment: How much money you earned if somehow you knew in advance what the GDP growth for that quarter? Since the estimate of GDP comes one month after the end of the quarter and the final – three months later, the experiment of Deluard requires considerable dose clairvoyance. But even assuming we are clairvoyants, it does not help us much. Deluard builds a portfolio that wholly invests in shares if we know that GDP growth over the quarter will exceed that of the previous, and entirely in cash if the growth is lower.
It turns out that the return on this portfolio is lagging behind the simple strategy of buying and retention of shares with an average of 1 percentage point per annum for the period 1948 to 2018.
What is the conclusion? Even if profits in the coming weeks and months are disappointing, do not automatically accept that it would be bad for the stock exchange.