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Can earnings afford to slow down?

Are we nearing the peak of earnings growth?

We are riding an historic wave of higher earnings and higher earnings revisions on the back of tax cuts and the global economic expansion.

However, just in the last couple weeks, analysts have begun to introduce 2019 earnings estimates for the companies they cover.

The good news: Most are expecting the record earnings wave will continue, with the S&P earnings up 10 percent in 2019.

The bad news: This is much lower than the earnings growth of roughly 17 percent expected in 2018.

Sure, it’s easy to say, “Hey, earnings are still likely going to rise 10 percent next year, so what’s the worry? Another year of double-digit earnings growth is still pretty good, right?”

Except it might not be good enough. Here’s the problem: Stocks are pricey. Right now, the S&P 500 is trading at roughly 18.5 times earnings estimates for 2018, well above historic averages of 15 to 16 times.

That can be justified, bulls argue, because earnings are continuing to accelerate and we are in the midst of a global economic expansion.

Fair enough. But in 2019, earnings will keep growing, but likely not at the pace we will see this year.

That’s a problem. That is earnings growth deceleration. Bears will likely start to pounce on the bulls, arguing, “You can’t say that the S&P should have this high multiple of 18.5 when earnings growth is decelerating!”

So what should be the right multiple? That’s not clear, but decelerating earnings growth would certainly imply a lower multiple.

Let’s say the multiple should be back closer to its historic levels. Let’s pick 16. With a multiple of 16, based on the just-introduced 2019 earnings estimate of $165 for the S&P 500, we come to a reasonable value for the S&P 500 of 2,640 (16 x $165 = 2,640).

Uh-oh. Remember, this is an estimate for what might be a fair value for the S&P 500 in 2019: 2,640. But the S&P closed at 2,853 on Monday, about 200 points higher than the projection.

You see why this issue of decelerating earnings is very important? Even if these are 2019 earnings estimates, the market will quickly turn its attention to those numbers, because stocks tend to react to perceptions of earnings about one year out.

To be fair, many analysts are so amazed by the upward earnings revisions for the fourth quarter — and now the first quarter — that they are just not that worried about 2019, at least not yet.

Nick Raich from the Earnings Scout is one of them: “Earnings will typically go down toward the end of earnings season as companies start to report, but not now. For the first time in seven years earnings estimates are going up.”

“If you are looking to be bearish now, it’s not on the earnings front.”

Raich is not worried about that 10 percent earnings growth for 2019 because he considers it an early estimate, a placeholder of sorts: “It’s pretty standard for analysts to predict 8 to 12 percent growth in the following year because those are typical earnings growth rate estimates,” he said. He believes that estimates will likely rise as the year progresses and thinks it is good news that the estimates are only up 10 percent.

“If analysts had come in with initial estimates of 20 or 30 percent growth in 2019, that would have been a problem, because everyone would suspect that is not sustainable,” he told me.

Others are not so sure. Christine Short, who tracks earnings for Estimize, told me, “Deceleration in growth won’t be good. Take big tech for example. We saw a rotation out of tech last quarter as valuations got too high, and even though they beat big time for the third quarter they got nothing out of it. Investors want to see continued upward growth to validate these high P/E’s.”

Just to fortify her point, she brought up three big tech names:

  1. Facebook Q3 earnings beat by 30 cents, earnings grew 46 percent year over year. Revenues grew 47 percent year over year. Stock fell 2 percent by the close the following day: “Investors finding it hard to justify 35x P/E ratio, especially in light of increased spending on security and content that will take a bite out of profits.”
  2. Intel Q4 earnings beat by 22 cents, grew 37 percent. Revenues grew 4 percent. Stock only increased 1 percent, P/E currently stands at 26 times forward earnings.
  3. Adobe Q4 earnings beat by 11 cents, grew 40 percent. Revenues grew 25 percent. Stock increased 1.4 percent in the following day, P/E currently stands at 59 times forward earnings.

Her conclusion: The big tech names in particular “will need really big beats to justify the high P/E. Any kind of deceleration would be an issue.”

Source: Investment Cnbc
Can earnings afford to slow down?

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