With all the recent talk on weak manufacturing numbers, endless trade wars, and the impeachment inquiry, few commentators have pointed out that we may be in the midst of a technical earnings recession. And given the high value we place on corporate earnings here at Zacks Investment Management, this is a factor we’re most certainly monitoring closely.
The background: As I write, we now have Q3 results from 74 S&P 500 members, which account for about 20% of the index’s total market capitalization. So far, the results are mixed – total earnings (aggregate net income) for these 74 companies are down -3% from the same period last year on +3.2% higher revenues. When we combine the results from these 74 companies with our estimates for the yet-to-report companies, total earnings are expected to be down -4% from the same period last year on +4.1% higher revenues.1
In the second quarter, the blended earnings decline for the S&P 500 was -0.4%, which was about the same as the decline in Q1. Put this all together, and that’s where the earnings recession narrative comes from.
It may feel to many readers like the odds are stacked against this bull market, and an earnings recession may be one more reason to err on the side of caution. But before changing your mind – and potentially your asset allocation – consider a few silver linings in the earnings story.
Let’s start with the second quarter. The blended earnings rate for the S&P 500 was indeed -0.4% from the previous year, but 75% of all companies reported a positive earnings-per-share (EPS) surprise and 56% of companies reported a positive revenue surprise. The 5-year average of companies beating earnings expectations is 72%, so even with negative year-over-year EPS growth the 75% beat rate is ultimately a positive result.1
Fast forward to Q3, and we’re seeing a similar trend forming. So far, 83.3% of reporting S&P 500 companies have beaten EPS estimates and 59.5% have reported beating revenue estimates. Assuming this trend largely holds, we could see another quarter where more companies are beating earnings expectations than normal. And that’s a good thing.
There is another factor in play, too, that I believe investors should bear in mind. S&P 500 companies are facing an uphill battle for earnings growth, considering the tough comparisons to last year when growth was boosted by the tax cut legislation. We expected this to weigh on earnings growth in 2019, and many corporations warned that this would be the case. I think that’s one of the reasons why we’re seeing strong performance from the S&P 500 this year, even as year-over-year earnings come in slightly negative.
The sector with some of the toughest comparisons is Tech. The Tech sector is the biggest earnings contributor in the S&P 500 index, bringing in 22.9% of the index’s total earnings in the forward four-quarter period. It follows that weak earnings in tech can be a major drag to total S&P 500 earnings. If we are excluding the tech sector’s drag, the estimated total earnings growth for the remainder of the index would be down only -1.8% (-4% with tech included).
As we drift further from the effect of the tax cut, we expect the year-over-year comparisons to normalize a bit with earnings growth coming back into the positive in the quarters ahead:
Bottom Line for Investors
Moderating U.S. economic growth and notable slowdowns in other major global economic regions are certainly a factor in the S&P 500 year-over-year earnings declines. Uncertainty about the global trade regime and increasingly protectionist policies are not helping matters either. But investors should consider that S&P 500 companies are currently facing very tough comparisons from last year, and even still, more companies than average are reporting better-than-expected results. As we drift away from the tough comparisons and maybe – just maybe – get some clarity on trade, I think the earnings picture will improve and return to positive year-over-year growth.