Stocks Are Facing Unprecedented Earnings Expectations
(Bloomberg View) -- The U.S. stock market is off to a strong start this year, and perhaps the biggest reason is the unprecedented expectation for big gains in earnings. This week is critical for those expectations as more than 100 companies are set to report, which could set the tone for the next several months. We have no history with companies beating sets of forecasts this aggressive.
To understand why, consider the chart below, which shows the “blended” median growth rate forecast for fourth-quarter 2017 operating earnings for the members of the S&P 500 Index. Blended means that as a company reports results, the estimate is replaced with the actual results. The last point on the chart is Friday, of which 53 were actual results and 447 were estimates. Before the quarter ended on Dec. 31 (gray vertical line) it was 500 estimates and no actual results.
What’s notable is that the earnings growth rate bottomed on Oct. 27 and rose through the quarter. This has never happened in the post-financial crisis era.
The next chart of the last 12 quarters shows that, except for the fourth quarter of 2017 (upper blue line), the pattern is always the same. That is, analysts are too optimistic when the quarter is several months into the future. Then they cut their estimates aggressively, usually every week, until the quarter ends (gray vertical line), then growth rates “bounce” higher. Although the chart just shows the last 12 quarters, that’s for readability. All the quarters since the second quarter of 2009 -- the end of Great Recession -- are the same, except for the most recent one as seen in the upper blue line.
The next chart shows the percentage of companies that beat Wall Street’s most recent estimates. Note that it has been 20 years since less than 50 percent of companies failed to beat expectations. The post-crisis period has averaged 69 percent (black line). Even in the fourth quarter of 2008, when the world was falling apart and the S&P 500 reported its worst quarterly loss ever, 58 percent of companies still beat expectations!
Why? The answer is because analysts and companies are happy to “game” earnings. Companies will offer guidance and analysts will keep their forecasts as low as possible so companies can beat expectations to the accolades of “great quarter, guys” on the earnings calls. The average “bounce” during earnings reporting season is 3 percent (plus or minus 1 percent). Note in the chart below that the fourth quarter of 2017 is not shown as only 6 percent of the companies have reported as of this writing.
So why did analysts break with precedent and hike their estimates throughout the fourth quarter? The next chart shows an index of company-offered guidance reached an eight-year high in the last week, suggesting companies are very optimistic. The index is a three-month average because companies typically offer guidance once a quarter.
Analysts are not just taking their cue from the guidance they are getting from companies to boost their estimates for this quarter alone. As the next chart shows, full-year 2018 earnings estimates are going through the roof. Such a spike higher is also unprecedented in the post-crisis period.
So, maybe the recent strength in equities is justified. If the estimates for 12 percent earnings growth prove accurate, and 70 percent of companies beat the estimates, as is typically the case, this will push the growth rate to a range of about 14 percent to 16 percent. Add to that full-year 2018 earnings estimates of 18 percent, and earnings are expected to be 36 percent higher in the two years ending Dec. 31, 2018.
The S&P 500 is up 28 percent on a total return basis since Dec. 31, 2016, and it could rise an additional 6 percent the rest of this year before any expansion to price-to-earnings multiples.
That said, be warned. Never have we seen year-ahead earnings estimates spike as much as they have in the last few weeks. Should any of this prove to be too aggressive and companies disappoint, the stock market could run into problems. Otherwise, the rally of the last year is in keeping with expectations of booming earnings expectations.
This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.
Jim Bianco is the President and founder of Bianco Research, a provider of data-driven insights into the global economy and financial markets.
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