Seeking a scapegoat for October’s stock market convulsions? Try the dark cloud looming on the horizon known as peak earnings growth.
With profit growth poised to slow sharply in 2019 for a number of reasons – chief among them less of a jolt from the Trump tax cuts – the market swoon happening today likely reflects the bottom line reality ahead.
“The market is pricing in the [earnings growth] slowdown now,” Blackstone vice chairman Byron Wien tells Yahoo Finance.
Welcome to the twilight zone of corporate profit growth – a no man’s land where growth is still OK, but not enough to please the bulls hooked on the red-hot years of 2016 and 2017.
By the Numbers
Igniting a flame under earnings the past two years has been the tinder of low interest rates, tame inflation and a steady jobs market recovery. That caused investors to rotate into riskier pockets of the equities market, tech names like Facebook (FB) and Alphabet (GOOGL, GOOG). But that gasoline has just about burned out.
And with it, probably comes a period of unspectacular earnings growth. The deceleration has already started, in fact.
Third quarter earnings growth is pacing at 19.5% year over year, cooling from the second quarter’s torrid rate of more than 25%, according to FactSet. Current fourth quarter earnings estimates have companies reporting profit growth of 16.5%. If hit, that would be being the full year to more than 20%.
For 2019, Wall Street expects earnings growth of about 10%. But the first half of the year may be in the 7% growth ballpark, FactSet estimates.
Amid such a noticeable slowdown, the always forward-looking market is naturally getting antsy into year end. The Dow Jones Industrial Average (^DJI) is down 5% over the past month, the S&P 500 (^GSPC) has shed 6% and the Nasdaq Composite (^IXIC) has pulled back 7%. Investors have rotated out of risker names such as Facebook (down 8% in the last month) and into perceived safe-havens in the healthcare and consumer staples spaces.
‘The reason this inflection point matters …’
Historically, stocks have not had an easy go of it when earnings growth comes off its peak. Based on the past six U.S. expansions dating back to the early 1970s, J.P Morgan notes that stocks have only outperformed bonds for another two months on average after earnings growth peaks. Stock outperformance vs. bonds has never continued for more than a year after profit growth has reached a climax, the investment bank says.
“The reason this inflection point matters is that it tends to overlap – give or take a few months – with some of the most material rotations that investors make within global portfolios,” points out J.P. Morgan head of cross-asset strategy John Normand.
And the fall from grace for earnings may be worse than the market expects at the moment, suggests Morgan Stanley U.S. equity strategist Mike Wilson. The strategist, who thinks we are witnessing the start of a rolling bear market that sees riskier parts of the market sell-off first before safer ones lose steam, outlined multiple reasons to be bearish on profits into 2019. Some of them include: rising raw materials prices, surging freight costs, higher interest rates, an escalating U.S./China trade conflict and sub 3% GDP growth.
“Margin downside has negative implications for U.S. equity benchmarks as the rate of change in operating margins is now strongly correlated with stock prices—a trend we expect to continue as the end of the cycle approaches,” Wilson says.
The bottom line
Not everyone thinks peak earnings growth is a major market risk for 2019. Remember, earnings growth is much better than seeing outright declines during a period of meager U.S. economic growth or worse, a recession.
“I don’t think that the peak earnings growth is necessarily a big issue for the market for next year. Investors already know that earnings received a big boost from the fiscal stimulus that won’t be repeated and that should partially be discounted in the market,” SunTrust chief market strategist Keith Lerner tells Yahoo Finance.
Lerner thinks that if companies can deliver on current earnings expectations, even if they are cut back a little, the markets should be able to do just fine. Even Blackstone’s Wien notes that 10% plus earnings growth in 2019 would be pretty good.
Tell that to a market hooked on 20% plus earnings growth every quarter though. Until the new normal for 2019 is understood by investors, a convulsing market is likely to be in the cards…for now.