Market Insights: U.S. earnings recession about to end

 

U.S. earnings recession about to end

According to data from Thomson Reuters, the S&P 500 is, surprisingly, now on pace to grow its earnings in the third quarter, ending a U.S. corporate earnings recession that has spanned five straight quarters.  This is on the back of a strong earnings season where 68% of companies that have reported Q3 earnings to the end of last week have beat estimates.  This would mark the highest “beat rate” (although it may not hold as not all companies have reported) since the fourth quarter of 2009.  But, in any case, this will surely remain the highest beat rate since 2010.  Another positive is that revenue growth will also be positive, ending six straight quarters of declines going all the way back to the fourth quarter of 2014.  In addition to what has so far been reported, we are also seeing better forward guidance, with far fewer earnings warnings from companies than we have seen at this point in the year, for the past five years.  In other words, the net number of companies lowering guidance is less than half of what it has been at this point for all years since 2010.

 

 

Source:  Bespoke Investment Group

This is very encouraging, and helps to support our belief that we are transitioning from an interest-rate driven bull market to an earnings-driven bull market.  This is a theme we discussed in our third quarter market commentary, one that will likely warrant a more active approach to investment management, especially from a sector perspective.  We continue to believe that the fundamental backdrop for equities justifies above average valuations, particularly with continued accommodative central banks and with dividend-to-government bond yield spreads at very high levels (especially here in Canada) keeping their relative value in check.  There are certain market pundits that are well-covered in the media who continue to say that equities are at historically high valuations (particularly referring to cyclically-adjusted price-to-earnings ratio) and advise investors to stay away from markets; however, they have been repeating this message for quite some time now, and investors heeding that advice would have missed out on most of the U.S. equity bull market.  In our view, there are also many metrics that show that equity markets are fairly valued (forward P/E, earnings yield, price to book).  It is important to rely on a vast array of metrics and perspectives.  Relying on one variable, or even two or three, is not enough to formulate a successful investment process over the long-term.    

Taking a recent quote from Rich Bernstein of Richard Bernstein Advisors (RBA) to describe our thoughts on this point:

"Some market observers have cautioned that overvaluation always leads to poor returns because multiples contract. There is indeed history to support such concerns. However, the key word is “always.” As we have shown, there have been many periods in stock market history during which earnings growth improves, interest rates increase, PE multiples contract, and a bull market continues. They are called earnings-driven bull markets. It is always headline-grabbing to predict a calamitous end to a bull market, and a broad range of sentiment data strongly suggests investors are quite scared. At RBA, however, we continue to swim against that fearful tide, and our portfolios are positioned for a cyclical rebound in earnings and an earnings-driven bull market."

Some of what he says rings true for us, although we are likely exercising a bit more caution based on some of the near-term uncertainties we discussed in our last quarterly commentary.  We do feel that these will come to pass, and that some patience in the near-term will be rewarded.  Rich’s comment on investors being scared is certainly evident though, in widely followed surveys.  We continue to see a large amount of negative sentiment among individual investors.  What is difficult to ascertain from the chart below is just how long bullish sentiment has been low.  This week’s sentiment report also marked another milestone as bullish sentiment was below 40% for the 52nd straight week.  In fact, since March 2015, bullish sentiment has only been above 40% once (one out of 87 weeks).  This, in our view, is not a sign of a near-term market top.

 

Source: Bespoke Investment Group