By: Costas Bocelli — July 17, 2019
It’s that time again…
The start to second quarter earnings season is underway.
The "big money" banks set the pace with many exceeding analyst’s expectations, including JPMorgan Chase (JPM), Wells Fargo (WFC) and Goldman Sachs (GS).
(Click any image to enlarge)
While the banks kicked things off on a positive note, the reality of the situation is that this batch of quarterly reports is widely expected to be a real stinker.
You see, according to FactSet Analytics, earnings growth for Q2 2019 is estimated to decline for the S&P 500 by -3.0% as compared to the same quarter a year ago.
If that turns out to be accurate, it will mark the first time the S&P 500 has reported two straight quarters of year-over-year declines in earnings since the first half of 2016 (Q1, Q2).
In other words, the stock market is in the cross hairs of an earnings recession.
I’m sure you’ve heard of an economic recession, defined by at least two consecutive quarters of negative GDP growth. The last economic recession was a doozy, following the great credit crisis of 2007-2008. The recession officially ended in the second quarter of 2009 as growth finally returned and real GDP turned positive.
Fortunately, the economy has managed to avoid back-to-back quarters of negative economic growth ever since, making this economic expansion the longest in history. Last month marked the ten year anniversary of the current economic growth cycle.
Now, an earnings recession is also defined in a similar fashion as there needs to be at least two consecutive quarters during which S&P 500 earnings declined as compared to the year prior.
The last time there was an earnings recession was in 2015 and 2016.
It started in the second quarter of 2015 and didn’t end until the second quarter of 2016.
That’s five consecutive quarters of negative earnings growth!
As you may suspect, stocks had a pretty tough time during the earnings recession.
In fact, the stock market suffered two corrections, one began in August of 2015 and another one, which was a bit more severe, occurred at the beginning of 2016.
Now here’s an important observation…
Notice that the stock market had bottomed in early-2016 (green arrow) while S&P earnings were still contracting (June Q2 2016 was the last quarter of negative earnings growth).
You see, the stock market is a forward looking machine, and it anticipated that the earnings recession was nearing an end.
Typically, if the stock market gets it right, it’s about six months ahead of the information that investors tend to react to in real time.
This is precisely the reason why most investors get caught into the trap of selling on major lows and get stuck buying at major tops.
And Mr. Market was spot on, bottoming-out about six-months before earnings growth was about to turn positive and re-accelerate.
By the time investors figured out that the earnings recession was over, the S&P 500 had already rallied from 1,800 to 2,100, a gain of +17%!
Earnings have been growing ever since... until the start of this year.
In the first quarter of 2019, S&P 500 earnings declined by -0.6%.
It’s a small decline, but nevertheless, profit growth contracted.
Now with the expectation of a decline in earnings of -3.0% for the second quarter, investors are right in the cross hairs of another earnings recession.
To be sure, many investors will fear the worst and abandon U.S. Equities.
Are you going to be one of them?
Will an Earnings Recession Kill the Bull Market?
They say earnings growth is the mother’s milk for the stocks.
If you simply ignore all the noise and distracting headlines and just follow the evolution of earnings growth, you’ll always be on the right side of the market in the long run.
Just have a look at the S&P 500 performance as compared to the 12-month forward EPS since the recovery began in 2009.
When earnings are weak or contracting, as was the case in 2015-2016, the stock market can run into a brick wall.
But when earnings are on the rise, the stock market goes with them.
It’s no coincidence that the S&P 500 is hitting new highs at the same time that the forward 12-month EPS is also at a record high. The current bottoms-up 12-month EPS estimate is $178 in operating earnings among S&P 500 companies.
Of course, things can drastically change.
But what Mr. Market is seeing right now is that earnings growth is going to return within six months or so.
Remember what I said; the stock market is a discounting mechanism.
Many investors will be distracted or sucked-in by all the news about the stock market being in an earnings recession, and end up allowing themselves to be baited into making ill-fated decisions.
The consensus forecast is that earnings growth is going to re-accelerate in the fourth quarter of 2019 and may even return to low double-digits EPS growth in the first half of 2020.
If that proves correct, then Mr. Market has got this right and the S&P 500 will move above and beyond 3,000 in the months ahead.
U.S. Equities is in a strong position in terms of asset class relative strength.
Large-cap growth has been and continues to be the best performing investment style.
And Technology remains the dominant broad sector.
Sticking with what’s been working is a proven method to generating superior returns.
Within technology, the Software sector has been a rewarding group for bullish investors.
Take the Invesco Dynamic Software ETF (PSJ) as an example. This exchange traded fund that offers broad exposure to a basket of leading software companies has gained +36% year-to-date, as compared to the +20% gain in the S&P 500.
In Profit Skimmer, my options research and trading service, subscribers recently were able to close a winning trade in Adobe (ADBE), a software company, and bag profits of +74% or more!
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Until next time!