Stocks Rally In The Face Of Weak Estimates

With earnings season about to get underway next week, the story about how much earnings expectations have fallen in the past two months is being reported by the media. This could change the sentiment in the market which has been riding high in the past two months. Even though stocks were modestly down on Monday as the Nasdaq QQQ ended its 9 day winning streak, the market still is on a remarkable run. As you can see from the chart below, the 1 month return prior to earnings season is the best in five years despite the fact that earnings revisions are the worst since the earnings recession. There was a 2 quarter stretch this year where we finally saw a return to solid earnings growth as estimates weren’t cut much and then they were beat. That combination had been rare since 2014. Now after reaching the 2014 height, estimates are crashing. The question is whether this is a new trend or a one off. Are the trailing twelve month earnings about to have a double top? If that occurs, stocks will be way overvalued because they rallied in the time it took for earnings to recover.

It may seem like I’m overexaggerating the divergence because stocks have only rallied 3.6% in the past month. However, the S&P 500 is up 4.91% in the past 7 weeks while this decline in estimates has been happening. According to Factset, S&P 500 earnings growth is only expected to be 2.8% year over year. Some investors who claim stocks are a buy as long as earnings are increasing, are perma bulls. You can’t say that 2.8% growth is positive after we had double digit growth in the first half. As I have been saying, the guidance given in Q3 will determine my stance on stocks. Bad guidance implies that this weakness is sustainable; it would cause me to switch to being bearish on stocks. On the other hand, if this is all about the hurricanes, then stocks won’t miss a beat. The S&P 500 will break the record long streak without a 3% correction and the streak without a 5% correction. The chart below shows the expectations rebounding in Q4 and the first 3 quarters of 2018. The counter point to this optimism is that many investors were optimistic about Q3 a few months ago, so the same decline can be repeated. At the end of last year, earnings estimates for 2017 earnings growth were in the low to mid teens and now it’s only expected to be 9.2%.