Forecasts of U.S. corporate earnings in 2019 are heading sharply downward, and some analysts even see an earnings recession, with profits lower than in 2018. Based on this scenario, abandoning equities seems to be a logical response, since earnings are the key driver of stock prices. Not so fast, say analysts at JPMorgan.
"Many believe that one can't buy stocks before earnings stop deteriorating. We continue to disagree with that view," as Mislav Matejka, head of global and European equity strategy at JPMorgan, said in a research note excerpted by CNBC. Looking at the last four cycles during which earnings estimates trended downward, his team finds that stock prices started rallying an average of seven months before those estimates started heading up again, posting a 30% average gain in the interim. The table below contrasts the 2019 earnings forecasts for the S&P 500 from bullish Goldman Sachs and bearish Morgan Stanley.
2019 Earnings Outlook: Bulls and Bears
(Base Case S&P 500 Earnings Growth)
- Morgan Stanley: +1%
- Goldman Sachs: +6%
Sources: Morgan Stanley 2/19/19 U.S. Weekly Warm-Up report; Goldman Sachs 2/15/19 U.S. Weekly Kickstart report
Significance for Investors
Earlier in this decade, Matejka and his team were rated as the best analysts in their category for four consecutive years by Institutional Investor magazine, CNBC notes. The most recent negative earnings cycle that they point to occurred in 2015-16. From Feb. 2016 to Dec. 2016, the market rose by 20% even though earnings continued to be revised downward, on average, during that same period.
In fact, throughout the current bull market that began in March 2009, expectations about earnings have generally been negative, JPMorgan adds. Breaking that time span into shorter periods, they find that earnings revisions were generally negative 64% of the time, but stocks were up 60% of the time.
Apart from their analysis of history, JPMorgan also bases their current optimism about stocks on four fundamental factors: dovishness by the Federal Reserve, the U.S dollar peaking in value, improved economic growth in China, and a positive outcome for trade negotiations between the U.S. and China. Of course, should they prove to be wrong, further declines in earnings are likely. Taking the U.S-China trade situation as one example, Citigroup recently issued a rather pessimistic assessment.
However, investors have shrugged off earnings disappointments recently. According to analysis by FactSet Research Systems cited by CNBC, companies that missed their earnings estimates for 4Q 2018 have seen an average stock price drop of only 0.4% during the two days following the announcement, whereas a decline of 2.6% would be in line with history. This is the lowest penalty for earnings misses since 2Q 2009, FactSet adds. Indeed, JPMorgan points out that several companies have recorded big price jumps after reporting an earnings miss, including an 11.6% gain for beleaguered General Electric Co. (GE).
JPMorgan believes that earnings forecasts can be back on a upswing as early as the second half of 2019. Based on their analysis of previous negative earnings revision cycles, right now they recommend cyclical stocks such those in the energy and mining industries, rather than defensive stocks.
On the other hand, bearish Morgan Stanley says, "With the US equity market so overbought, fully valued and the beta trade somewhat overplayed at this point, we think it makes sense to keep our overweights on Utilities and [Consumer] Staples." That is, they recommend the opposite, a tilt toward defensive stocks.