Earnings Are Set to Drop Again. Investors Seem Fine With That

(Bloomberg) -- Corporate profits likely dropped for a second straight quarter at the end of 2019, dragging down annual earnings growth to the smallest in three years. A lot of investors are fine with that.

Put it down to the nature of the stock market, where returns tend to anticipate changes in earnings growth. As the S&P 500 notches records, investors are focused on forecasts for a rebound in profits this year. If history is any guide, getting through this trough in the earnings cycle bodes well for 2020 -- the equity benchmark has, on average, gained more than 7% following a bottom in profit growth.

“The market is pricing in an earnings increase,” Chris Gaffney, president of world markets at TIAA, said in an interview at Bloomberg’s New York headquarters. “The environment overall is very good.”

JPMorgan Chase & Co. is among the big banks that kick off the reporting season Jan. 14. Analysts are projecting that S&P 500 profits fell 1.6% in the last three months of 2019. Investors will likely pay closer attention to forecasts to see if companies confirm the rebound currently expected by analysts -- a 3.2% rise in the first quarter of 2020, with a full-year forecast of 9.1% growth, according to data compiled by Bloomberg Intelligence.

Such a setup has brought solid equity gains in the past. In 1998, earnings bottomed in the fourth quarter and the S&P 500 returned close to 20% in the subsequent four quarters. Similarly, in 2016, EPS growth troughed in the first quarter and the index went on to gain 15% over the following year, according to an analysis by Bloomberg Intelligence.

As the reporting season nears, analysts are growing even more optimistic about 2020. The earnings revision ratio, which measures the number raising forecasts versus those cutting them, has been trending higher. JPMorgan strategists led by Mislav Matejka expect that to continue. Profits won’t contract unless the economy is in a recession, they wrote in a note.

“In other words, one needs to believe that a full-blown recession is imminent to be bearish on earnings from here,” they said.

While the recent flare-up in tensions with Iran has investors on edge, the trade truce between the U.S. and China has many betting on a pickup in global growth this year. The S&P 500 needed just two days to bounce back from the Iran-fomented sell-off, notching its 12th weekly gain in the past 14.

American companies are hiring at a solid pace, with the unemployment rate at a half-century low of 3.5%. The manufacturing sector is showing weakness, but other areas continue to surprise. A rebound in sales and production lifted a service activity gauge to a four-month high in December, exceeding the median economist projection.

“In the short- to medium-term, we’ve seen a bottoming in the economic picture almost globally, especially in the major developed countries and China, too,” Michael Reynolds, investment strategy officer at Glenmede, said by phone. “That’s 100% good for risk assets. A growing base of economics is what could grow the earnings base and that’s certainly a positive.”

Both small and large-cap stocks are seeing improving revision ratios based on a three-month rolling average, according to Jefferies. More importantly, the uptick has been broad, with cyclical sector revisions firming up, wrote strategists Steven DeSanctis and Eric Lockenvitz in a recent note. This “makes us more comfortable about better earnings growth in 2020 and even more important, broadening earnings growth that supports our cyclical tilt and head overseas,” they said.

Cyclical sectors of the market are expected to lead the rebound in earnings growth this year, with energy stocks set to see growth of 21%. Industrials and materials are each forecast for rises of about 14%, according to data compiled by Bloomberg.

But, “a lot more needs to go right on the macro front in order to be able to achieve those earnings estimates,” Emily Roland of John Hancock Investment Management told Bloomberg TV on Tuesday. “Investors priced an awful lot in at the end of 2019.”

To Morgan Stanley Wealth Management’s Lisa Shalett, earnings revisions remain concerning. Even as the forecast for total profit improves, there have still been more negative revisions than positive ones, said the firm’s chief investment officer in a Bloomberg TV interview on Tuesday. Many earnings forecasts are still being cut and economic growth has been lackluster.

“Folks are going to have to at some point do the math. I continue to remind clients fundamentals matter in the intermediate- to long-term,” Shalett said. “Ultimately, there will be a day of reckoning.”

To contact the reporters on this story: Vildana Hajric in New York at vhajric1@bloomberg.net;Sarah Ponczek in New York at sponczek2@bloomberg.net

To contact the editor responsible for this story: Jeremy Herron at jherron8@bloomberg.net

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