Q3 earnings season: Stud or dud?

Preface: Explaining our market timing models
We maintain several market timing models, each with differing time horizons. The “Ultimate Market Timing Model” is a long-term market timing model based on the research outlined in our post, Building the ultimate market timing model. This model tends to generate only a handful of signals each decade.

The Trend Model is an asset allocation model which applies trend following principles based on the inputs of global stock and commodity price. This model has a shorter time horizon and tends to turn over about 4-6 times a year. In essence, it seeks to answer the question, “Is the trend in the global economy expansion (bullish) or contraction (bearish)?”

My inner trader uses the trading component of the Trend Model to look for changes in direction of the main Trend Model signal. A bullish Trend Model signal that gets less bullish is a trading “sell” signal. Conversely, a bearish Trend Model signal that gets less bearish is a trading “buy” signal. The history of actual out-of-sample (not backtested) signals of the trading model are shown by the arrows in the chart below. Past trading of the trading model has shown turnover rates of about 200% per month.

 

The latest signals of each model are as follows:

• Ultimate market timing model: Buy equities
• Trend Model signal: Risk-on
• Trading model: Bullish

Update schedule: I generally update model readings on my site on weekends and tweet any changes during the week at @humblestudent. Subscribers will also receive email notices of any changes in my trading portfolio.

Is the earnings recession over?

Regular readers will know that I have been bullish on stocks for the last few months. My forecast has called for an equity rally into year-end and beyond. Last week, a couple of Street strategists have turned cautious on the stock market. I would therefore like to examine the bear cases that they present.

Bloomberg reported that Goldman Sachs strategist David Kostin set an SPX year-end target of 2100. The main reason for the bearish call is earnings disappointment.

“Variables that determine earnings surprises – changes in U.S. economic growth, interest rates, oil price, the dollar, and EPS [earnings per share] revisions – suggest a below-average share of firms will report positive earnings per share surprises (43 percent vs. 46 percent),” he writes in a note to clients. ” We see a weak third-quarter reporting season coupled with negative fourth-quarter EPS revisions pushing stocks 2 percent lower to our year-end target of 2,100.”

 

 

Bloomberg also reported that HSBC strategist Ben Laidler also sounded a cautious note, based on valuation and likely earnings disappointment:

“We think markets are pretty vulnerable. You have earnings expectations which are pretty high, you have valuations which are pretty high,” he said. “You look around the world, the level of economic-policy uncertainty is very, very high — I think that is a dangerous combination right now.”

As I will show, at the core is the bull vs. bear debate is whether the earnings recession ended in Q3 2016.

How expensive are stocks?

First, I would like to address the issue of market valuation, which HSBC analyst Ben Laidler raised. How cheap or expensive is the stock market?

The indirect evidence does not suggest that the market is expensive. The latest update of insider activity from Barron’s shows that this group of “smart investors” have been steadily buying in the last few weeks. While insider trading data is noisy and readings can be volatile from week to week, it’s difficult to reconcile the idea of smart money buying an expensive market.

 

John Butters at Factset reported this week that the SPX trailing P/E ratio is 19.4. At first glance, that appears to be well above the historical average and that P/E ratio has only been exceeded by the market P/E during the Tech Bubble of the late 1990s. However, inverting the P/E ratio to an earnings yield of 5.2%. With the 10-year Treasury yield at 1.8%, there is a certain element of TINA (There Is No Alternative to stocks) that is supportive of the equity bull case.

 

What if interest rates were to rise? Wouldn’t that make stocks less attractive? Analysis from JPM Asset Management shows that when 10-year rates are below 5%, stock price movements are positively correlated with changes in interest rates.

 

Other historical studies have shown that stock prices tend to rise even when the Fed first starts a rate hike cycle. That’s because the Fed raises interest rates to cool down an economy that’s growing to quickly. The market initially focuses on the positive effects of better growth, rather than the negative effects of higher interest rates.

In the current environment where the Fed is about to raise rates, the equity valuation vulnerability issue becomes a question of whether better earnings growth can overcome the negative effects of a likely December rate hike. Is the earnings recession over? Can stocks continue to rise in anticipation of better earnings?

The earnings recession in context

To put the recent earnings recession into context, the latest Factset report shows that trailing 12-month EPS peaked in late 2014, along with the oil price, and they have been falling ever since (annotations in red are mine).

 

The bear case

The bear case rests mainly on deceleration macro data. The Atlanta Fed’s nowcast of Q3 GDP growth has fallen to 1.9%. The NY Fed`s nowcast stands at 2.3%. Both figures are considerably lower than the levels seen in late August when the nowcasts were in the 3.0-3.5% range.

 

At the same time, New Deal democrat`s monitor of high frequency economic data shows that the economy is starting to wobble. While long leading indicator remain strong, short leading indicators are starting to weaken, and coincident indicators are mixed. While the persistent mixed readings in the coincident indicators are reflective of the mild industrial recession, the deterioration in short leading indicators is more disturbing. NDD concluded:

A great deal depends on whether the recent lows in interest rates translate into an increase in the new housing market. This coming week we will get housing permits and starts, which assume even more importance that usual, especially as mortgage applications – positive for now – nevertheless look like they are getting ready to roll over.

In other words, don’t panic, but watch for more developments.

The bull case

While the bear case for equities stems from top-down macro analysis, much of the bull case can be attributable to bottom-up derived fundamentals. The latest Q3 estimate of YoY EPS growth is -1.8%, but Q3 may be the bottom for earnings growth (annotations in red are mine).

 

John Butters pointed out that a meagre -1.8% YoY growth estimate is not such a big hurdle. If results came in line with the beat rate results seen in a typical earnings season, it would be enough for EPS to return to positive YoY growth:

Over the past four years on average, actual earnings reported by S+P 500 companies have exceeded estimated earnings by 4.3%. During this same time frame, 68% of companies in the S+P 500 have reported actual EPS above the mean EPS estimates on average. As a result, from the end of the quarter through the end of the earnings season, the earnings growth rate has typically increased by 2.9 percentage points on average (over the past four years) due to the number and magnitude of upside earnings surprises.

If this average increase is applied to the estimated earnings decline at the end of Q3 (September 30) of -2.0%, the actual earnings growth rate for the quarter would be 0.9% (-2.0% + 2.9% = 0.9%). If the index does report growth in earnings for Q3 2016, it will mark the first time the index has recorded year-over-year growth in earnings since Q1 2015 (0.5%).

Much of the earnings recession can be attributed to a higher USD and lower oil prices. The chart below shows the JPM Asset Management estimate of the effects of USD strength on SPX revenues over the last few years.

 

The USD has been roughly neutral on a YoY basis in Q3, so the negative effects of USD strength are gone.

 

Here is the JPM Asset Management’s estimates of the effects of lower energy prices on SPX earnings.

 

On a YoY basis, oil prices are flat to slightly positive (see bottom panel).

 

Here is a chart of natural gas prices. The YoY effect is even more positive than crude oil.

 

As those macro headwind abate, is it any surprise that forward 12-month EPS are being revised upwards? In addition, Thomson-Reuters reported that Q3 earnings guidance, or preannouncements, has come in more positively than the historical experience.

 

The bond market seems to agree with the assessment of higher growth. Despite the rise in 2-year yields in anticipation of a December rate hike, the 2/10 yield curve steepened, which is an indication that the bond market expects rising growth.

 

At the end of the day, the key to stock prices will be the report card from Q3 earnings season. Will it surprise us on the upside or downside? While the signs of macro weakness are worrisome, I find it difficult to believe that Q3 earnings season will disappoint without any indications from the troops on the ground. Company guidance has been more upbeat than usual, and Street analysts have not found signs of aggregate deterioration.

The early results from earnings season is encouraging for the bulls. Factset reports that with 7% of index components having reported, the earnings beat rate is 76% (vs. 5-year average of 67%). The sales beat rate came in at 62% (vs. 5-year average of 54%). Moreover, the Q4 negative guidance rate is only 67% (vs. 5-year average of 74%). However, these results are highly preliminary and we should get a better idea of how earnings season is progressing next Friday.

One possible explanation for the divergence between top-down and bottom-up data analysis is the macro bears are reacting to lagging signals of economic weakness. The Citigroup US Economic Surprise Index (ESI) measures whether high frequency economic releases are beating or missing expectations. As the ESI chart below shows (gold line), the index had been falling but it has recently stabilized, indicating the start of a possible turnaround.

 

What could go right

There is a possibility that the bears have become overly negative. They have focused too much on the downside risks to the economy. Jim Paulsen at Wells Fargo Asset Management recently asked the question, “What could go right?”

Here are the upside risks that he named (shown in bold, with my comments after each bolded point):

• What if the global economy experiences a global bounce?
• What if the US finally adds a little leverage? These charts of the household finances (via JPM Asset Management) shows that the consumer has repaired her balance sheet and could be ready to spend again.