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Recent volatility in equity markets has been attributed to rising interest rates and concerns that U.S. equities will be unable to maintain what has been historically strong earnings growth. U.S. equities have sharply outperformed their international peers year-to-date, and much of that outperformance stems directly from strong earnings numbers, which have been bolstered by a robust U.S. economy and the effects of corporate tax cuts. At the end of the day, earnings and earnings projections are really all that matter in equity investing – the price of a stock is based on investors’ expectations that the company will deliver positive earnings, either now or in the future. In this post, we examine the prior quarters’ results, and look ahead to determine whether the earnings train will stay on track, or derail, in Q3.
In Q2 of 2018, the percentage of S&P 500 companies beating earnings hit 79.8%, while misses came in at 15.0%, and inline registered 5.2%. The chart below shows the S&P 500’s historical beats and misses since the 2nd quarter of 2012.
In the 2nd quarter of 2018 on a sector level; Health Care, Information Technology, and Consumer Staples had the highest beat percentages at 92.1%, 91.6%, and 90.3%, respectively. All sectors, except for Energy, had beat percentages outpacing misses. Energy had a beat percentage of 41.9% versus a miss percentage of 51.6%, with 6.5% being inline. We can see this in the following chart, ranking the S&P sectors by beat percentage from highest to lowest.
Of course, earnings “beats” are subject to analysts’ expectations, and if the bar is set too low, the data may be skewed. Investors should always look beyond the headline “beat/miss” news and look for insight on growth and profitability. Encouragingly, Sales and Operating Margins for the S&P 500 have both also hit new historical highs, as shown in the following charts. The companies of the S&P 500 are humming along, helping to boost the economy to new heights.
Looking ahead, third quarter earnings are just about to commence as market volatility has picked up amidst concerns over tariffs, rising interest rates and geopolitics. Economic data, however, remains supportive with improving wages, low unemployment, and moderate inflation. Earnings expectations are high but against the strong economic backdrop we should see strong numbers yet again from most companies. Last quarter’s laggard, the energy sector, should rebound thanks to higher oil prices. Financials should also perform well in the environment of rising rates, which increase lending profits. Corporate share buybacks increased 48% year-over-year in the first half of 2018 and should continue to boost earnings by lowering shares outstanding. The recent market pullback could encourage companies to expand share buybacks for the remainder of the year.
The biggest risk remains uncertainty over trade and tariffs. Investors will be watching closely to gauge the impact of tariffs on sales and earnings numbers and will also be closely monitoring forward guidance to see if companies are repositioning themselves in anticipation of a prolonged trade war. Any breakthrough in trade talks will certainly provide a significant upside boost for domestic and international equity markets. For proof regarding international equity markets look below at the charts of the Canada and Mexico ETFs. The charts show the relative performance of the Canada and Mexico ETFs (tickers EWC and EWW, respectively), with Canada compared to the broader International Developed Markets (represented by the ETF ticker EFA) and Mexico shown relative to Emerging Markets (ticker EEM). The U.S. and Mexico came to an agreement at the end of August, and Canada joined the pact at the end of September. Both countries have shown a recent increase in relative strength compared to their international peers, thanks in no small part to the breakthrough in trade negotiations with the U.S..
As for rising interest rates, they are still historically low and concerns that investors will suddenly abandon equities for fixed income may be overstated, particularly if U.S. companies can continue their strong earnings growth. If we consider that stocks in the S&P 500 “yield” approximately 5% annually in earnings, bond yields still do not offer a high enough return to push investors out of the equity markets. The 10-Year Treasury yield appears to have definitively broken out above 3%, but it would likely take rates rising to well above 4% to cause a substantial sell-off in the U.S. equity markets.Download PDF
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