This is part of an ongoing series of articles published by Johnson Financial Group. This issue is written by Brian Andrew, EVP, Chief Investment Officer.
As we often say, stock investors really only need to check in on the value of their holdings once a quarter. That's because public companies are heavily regulated as to how they communicate with the market. Their management teams are only allowed to provide detailed financial updates to their shareholders on a quarterly basis. This information adds needed perspective on a stock's value, so investors react by adjusting their prices. Post Enron, Reg FD provides rules for how much forward guidance companies can provide, and that limits what management teams can say. So while stocks need to trade five days a week, the quarterly updates are really where the action is. Here is what we're hearing this quarter.
During the fourth quarter last year, investor sentiment took a turn for the worse. In fact, sentiment in late December was more than 50% lower than it had been in September when the stock market peaked. Since Jan. 1, however, stocks have rallied over 10% and investor opinion of how weak things may get this year has moderated. Surprising, since 2019 earnings estimates for the 500 companies in the S&P 500 Index have declined by over 4% during this period.
Over the last 10 years the average decline in estimates for the first quarter declined by 1.8% according to Factset. So how is it that earnings estimates have declined at a faster rate, yet stocks have rallied considerably? Sentiment and the future expectations expressed by companies as they've reported earnings may provide the answer.
According to the AAII Bull/Bear survey of investor sentiment, the percentage of investors with a bullish outlook has risen from 32% to 40% since December, while bearish sentiment has fallen from 50% to 32%. This improvement in sentiment is likely a function of two things. First, recent news suggests that another government shutdown isn't likely and trade discussions with China are at a point where the deadline for higher tariffs may be postponed. The other important factor is that the guidance from companies reporting earnings so far this year isn't as bad as investors may have presumed it would be in December.
Last year was a great year for corporate earnings growth. During the third quarter, year‐over‐year growth was almost 28%. However, growth for the fourth quarter of 2018 looks like it will be closer to 13.5%. The magnitude and pace of this decline is what started stock investors on the path of worry in November and December. This, coupled with the aforementioned shutdown and trade concerns, led to the decline.
As the sell‐off in stocks gained momentum, however, it became clear that investors had become convinced that a recession was imminent in 2019 and corporate earnings growth would be negative. As we entered January, a return to a more reasonable perspective on growth, a Federal Reserve on hold, and the appearance of progress on immigration and trade have led to a different environment and the stock rally.
While companies in the S&P 500 Index are only expected to grow earnings by 4.4% in 2019, operating margins are estimated to be over 11%. This level of profitability should help sustain earnings growth at a time when a slower growing U.S. and global economy will reduce overall revenue growth.
When looking at the individual sectors of the stock market, we get a better picture of which companies were benefitting from the economy and which are having trouble keeping up. Energy had the best fourth quarter 2018 growth rate, with earnings expected to be up 158% over the prior year. Of course, that comes from a significant rally in oil prices during the latter half of the year. Materials companies had earnings growth of 31%. Financial companies benefitted from greater commercial loan growth and net interest margins growing by 26%. Sectors growing slowest so far have been consumer staples and discretionary companies, each showing little or no growth, and information technology.
Companies with more than 50% of their sales outside the U.S. are expected to grow revenue and earnings slower than those with sales that are more U.S.‐based. As you can see from the chart below, all of the companies in the S&P 500 Index are expected to grow revenue by 5.1% and earnings by 5%. Those with more than 50% of sales outside the U.S. should grow revenue by almost half as much and earnings 1/3 as much. We think this reflects the fact that while the U.S. and global economies are slowing, the average growth rate in the U.S. will provide more revenue and earnings growth than the growth of international developing and emerging markets.
We believe the negative sentiment that took hold of stock investors at the end of last year will continue to improve as companies release their earnings for the fourth quarter of 2018 and provide guidance for 2019 that doesn't sound as dire as some had believed. Still, we'll be mindful of the fact that trade talks with China aren't complete and the elimination of another government shut‐down isn't a sure thing. Investor sentiment is fickle and could turn negative if news stories on these fronts show lack of progress. However, earnings growth will likely be positive in 2019, and those fundamentals should help stock prices.
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