​Q2 Should Be Solid, and Guidance Is Key. Bulls Hope for Breakout

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Once again, investors are looking to the upcoming earnings season as the impetus to calm a market filled with macro uncertainty. The bulls would like the reports to result in a breakout and possibly new highs in the S&P 500 SPX, writes Lindsey Bell.

Unfortunately, while we expect the second-quarter numbers to be as impressive as the first quarter and guidance to be decent, we think the response from stocks will more likely resemble the reaction received after first-quarter results.

At that time, stellar reports were viewed as a “sell the news” type of event. On average, companies that beat both top-line and bottom-line expectations in the S&P 500 only traded 0.1% higher on the day they reported results, and many traded down sharply on the release. That was despite the market trading lower going into the reporting period, declining 4.4% in the month prior.

This time around, the S&P 500 is flat over the past month and there has been significantly less volatility over that period compared to the month prior to the release of first-quarter results.

The consensus projects second-quarter growth at 19.5% on EPS of $38.73. Consensus profit growth estimates have improved by about 50 basis points (bps) from a month ago, with the energy sector as the primary driver as it is expected to benefit from higher oil prices.

Most other sectors’ numbers have been reduced in the past month, which is a more traditional move for projections. History shows that, on average, estimates moved nearly 150 basis points (bps) lower in the four weeks heading into the earnings announcement period. Even though the S&P 500 estimate has moved higher this quarter, we view the current forecast as reasonable.

We expect this will be the second quarter in a row for earnings growth of greater than 20%, something that hasn’t been recorded since 2010 (a result of a rebound in earnings off recessionary declines). This time the robust growth rate is a reflection of strong sales growth and reduced tax rates from the new tax policy.

The few companies that already reported have announced strong results, with only two of 15 companies missing EPS estimates. Said another way, 93% of companies beat projections. On sales, 87% of companies have beat expectations to-date. Both beat rates are exceptionally strong, even for this early in the season.

Stock reactions, on the other hand, have been tempered, rising 0.5% on average, led by consumer discretionary and industrials. Notably, most early tech reports had negative reactions to results, declining 0.9% on average. Guidance has been a mixed bag for the sector with Oracle guiding below the consensus estimate for the current quarter and Micron handily raising its outlook.

Historically, quarterly growth ends 3.5%-4.5% points higher than the initial estimate, which would mean growth of 23% would be a possibility in the second quarter, following the 23.3% increase recorded in the first quarter.

EPS growth hasn’t fallen short of expectations since first quarter 2009 and six of the last seven quarters have reported better-than-average beat rates (of 7.0% in Q1 2018, 3.9% in Q4 2017, 4.4% in Q3 2017, 4.6% in Q2 2017, 5.8% in Q1 2017 and 5.2% in Q3 2016).

Forward Earnings Growth Spurt

Looking forward, 2018 EPS of $159.19 marks a record high for the S&P 500 and represents an increase of 20.9%. That would be the best annual earnings growth since 2010. After moving higher on tax reform and as fourth-quarter results began to be released in January, growth expectations pulled back slightly in mid-February.

First-quarter results and guidance led to another leg up in growth in May and the trend has continued slowly and steadily since then. Again, this is a very atypical trend. As the year unfolds, it is normal to witness annual earnings growth rates move lower. Specifically, growth can end a year 550 basis points lower than the January 1 estimate.

In relation to tax reform, we think several companies, especially in the technology space, will continue to allocate capital to buybacks.

According to Dow Jones Indices, first quarter buybacks totaled a record $189.1 billion, a 42% increase from first quarter of 2017. Additionally, buybacks were 9.9% higher than the prior quarterly record, set in the third quarter of 2007.

Tech sector buybacks increased 77.1% from the fourth quarter and represented 33.5% of the S&P 500’s buybacks.

Capital expenditures have increased 32.5% on average in the past three quarters, a surge from the average 3.9% decline in spending recorded in the three quarters following the 2016 presidential election. Capital invested internally via capex plans or wage increases support longer-term growth estimates.

According to The Business Roundtable CEO Economic Outlook Index, a survey of CEO projections over the next six months, its component for capital spending declined slightly given trade concerns but remained at high levels in the second-quarter survey. Recent trade tensions along with the current volatile market conditions may result in a delay of investment by corporations.

While we think capital expenditures will continue to increase in the second quarter, it will be important to follow spending guidance this quarter.

Digging into second-quarter earnings growth, the energy sector will lead with 139.8% growth as the sector continues to emerge from a two-year earnings recession.

Materials growth of 29.6% is the second best in the index as the group is benefiting from higher commodity prices and higher volumes.

After energy and materials, financials and information technology will lead with growth ahead of the index’s 19.5% rate. It will be the seventh quarter in a row that information technology is in the top three sectors for growth and the eighth quarter the sector recorded double-digit growth. In each quarter of the past six quarters, the information technology sector recorded growth of 21% or better.

A decline is only projected from the real estate sector (-3.8%) and the utilities sector (-1.5%). Other sectors reporting below-average growth are telecommunications (15.2%), industrials (14.1%), consumer discretionary (13.4%), health care (9.9%) and consumer staples (7.4%).

View CFRA, services and research including Marketscope Advisor here.

Lindsey Bell: Q2, Q3, the worst. Q4 good news here.

This articlewas originally published by MoneyShow.com: Founded in 1981, MoneyShow is a privately held financial media company headquartered in Sarasota, Florida. As a global network of investing and trading education, MoneyShow presents an extensive agenda of live and online events that attract over 75,000 investors, traders and financial advisors around the world.

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