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Inside the Market Investors could be in store for a rude awakening this earnings season

There is a strange cognitive dissonance around U.S. earnings season where equity strategists are making dire proclamations about rising risks, but investors seem broadly insensitive to the warnings.

The potential for significant market volatility is real. Over the past six months, both the S&P 500 and the S&P/TSX Composite Index initially sold off sharply on fears central banks were raising interest rates, then recovered strongly as central banks backed off. Focused on credit conditions, investors largely ignored the deterioration in U.S. corporate earnings expectations.

S&P 500 Earnings Estimates

For the first quarter of 2019

12%

10

8

6

4

2

0

-2

-4

April 1

July 1

Oct. 1

Jan. 1

April 1

April 8

2018

2019

S&P 500 actual Earnings/Estimates

Year over year, by quarter

30%

25

20

15

10

5

0

-5

Q1

Q2

Q3

Q4

Q1

Q2

Q3

Q4

Q1

Q2

Q3

Q4

Q1

Q2

Q3

Q4

2017

2018

2019E

2020E

JOHN SOPINSKI/THE GLOBE AND MAIL

SOURCE: scott barlow; REFINITIV

S&P 500 Earnings Estimates

For the first quarter of 2019

12%

10

8

6

4

2

0

-2

-4

April 1

July 1

Oct. 1

Jan. 1

April 1

April 8

2018

2019

S&P 500 actual Earnings/Estimates

Year over year, by quarter

30%

25

20

15

10

5

0

-5

Q1

Q2

Q3

Q4

Q1

Q2

Q3

Q4

Q1

Q2

Q3

Q4

Q1

Q2

Q3

Q4

2017

2018

2019E

2020E

JOHN SOPINSKI/THE GLOBE AND MAIL

SOURCE: scott barlow; REFINITIV

S&P 500 Earnings Estimates

For the first quarter of 2019

12%

10

8

6

4

2

0

-2

-4

April 1

July 1

Oct. 1

Jan. 1

April 1

April 8

2018

2019

S&P 500 actual Earnings/Estimates

Year over year, by quarter

30%

25

20

15

10

5

0

-5

Q1

Q2

Q3

Q4

Q1

Q2

Q3

Q4

Q1

Q2

Q3

Q4

Q1

Q2

Q3

Q4

2017

2018

2019E

2020E

JOHN SOPINSKI/THE GLOBE AND MAIL, SOURCE: scott barlow; REFINITIV

Investors could pay a high price for getting distracted. As shown in the first chart, profit expectations have drastically been ratcheted down for the coming U.S. earnings season, which heats up on Friday when large U.S. banks JPMorgan Chase & Co. and Wells Fargo & Co. report.

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Twelve months ago, year-over-year profit growth of 10.6 per cent was projected for the first quarter of 2019. These estimates have trended downward, and now the first decline in profits since 2016 is expected.

Morgan Stanley equity strategist Michael Wilson believes an extended, market-damaging earnings recession is on the horizon.

“With U.S. stocks fully valued, and the [U.S. Federal Reserve] maximum dovish at this point, we think there will need to be some evidence of a real turn in earnings growth for U.S. stocks to advance much further," he said in a report on Monday.

Mr. Wilson described coming profit reporting as a “gut check” for investors who want assurances that market volatility is a thing of the past.

Prominent Goldman Sachs equity strategist David Kostin is also predicting an extended slide in earnings growth. From 2018’s impressive 23-per-cent annual profit increase, the strategist expects full-year 2019 growth of 6 per cent and a meagre 4 per cent for 2020.

Merrill Lynch quantitative strategist Savita Subramanian has a slightly different perspective on profit growth for coming quarters. The strategist recently lowered her 2019 earnings forecast to 4 per cent (from 5.2 per cent) while noting that the current consensus estimate of 3.5 per cent is close to 23-year lows.

For Ms. Subramanian, 2019 profit forecasts already reflect enough pessimism. The larger concern is 2020, where the consensus earnings growth estimate of more than 12 per cent appears, to her, wildly optimistic. The seeming over-exuberance on 2020 profit estimates sets investors up for a long series of disappointments as growth expectations are repeatedly lowered.

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For Morgan Stanley’s Mr. Wilson, “The real question at this point is what the second half of the year looks like." Management earnings guidance for the remainder of the year will likely be as important as the first-quarter numbers themselves.

As the second chart highlights, analysts, on average, currently expect a significant jump in profit growth for the second half of 2019 and into 2020. Earnings are currently expected to climb by 9 per cent year over year by the fourth quarter of 2019, and average 12.8 per cent for 2020, well above Mr. Kostin’s projections.

All this could set up markets for steep declines if profits miss low expectations for the first quarter or downward earnings guidance forces investors to revalue equity prices lower to account for a flatter earnings growth trajectory for 2020.

It is important to note that while Ms. Subramanian, Mr. Wilson and Mr. Kostin are among the most respected sell-side strategists on Wall Street, not all analysts are losing sleep about first-quarter results. Credit Suisse U.S. equity strategist Jonathan Golub, in an April 8 research report, noted that if the same percentage of U.S. companies beat analyst estimates as usual, quarterly profit growth for the S&P 500 will come in at 2.5 per cent. In that case, all of this hand-wringing will have been for nothing.

Canadian investors with U.S. stock holdings need to pay close attention to forward earnings guidance from corporate management as results are reported. Year-to-date, the S&P/TSX and S&P 500 have shown a high degree of correlation, so domestic stocks are likely to share whatever fate befalls the U.S. market, at least to some extent. Further lowering of earnings estimates for the second half of this year and 2020 should be taken as a sign to reduce risk in equity portfolios.

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