The first quarter of 2019 included the best average quarterly gains for stocks and oil prices since 1998 and 2002 respectively. Even when including the surprise selling at the end of March, the S&P 500 was up 14.43% since January 1. As prices have become extended, it shouldn’t be a shock to see some angst building up among investors, and a temporary correction is probably due. In my view, how severe that correction winds up becoming is a function of what happens with the yield curve and earnings over the next few weeks.

Can Labor Breathe New Life Into the Yield Curve?

As most investors likely know already, the U.S. Treasury bond yield curve became inverted in March. This means that the 3-month interest rate on Treasury bills is above the 10-year interest rate on Treasury bonds. In the past, this has been a reliable signal for an inbound recession. However, history has shown that the length of time between an inversion and the recession is usually several months which gives investors more time to profit and make portfolio adjustments, even if it is a worst-case scenario.

A factor that can influence the yield curve (and its accompanying sign of recession) that is often overlooked is labor and wage growth rates. If labor and wages are rising in the U.S., inflation expectations should pick up. Interest rates on long-term Treasury bonds increase when inflation is expected to rise, that could un-invert the yield curve if the data is enough of a surprise.

The U.S. Bureau of Labor Statistics’ Non-Farms Payroll and Unemployment (NFP) report will be released on April 5; I think there is cause to expect a positive surprise. The NFP report is subject to seasonal adjustments to “smooth” the data and avoid the ups and downs of seasonal hiring. The actual number of jobs added is another estimate based on a small statistical sample gathered by the Bureau of Labor Statistics.

As you can imagine, these two estimates compound the potential errors in the data, and it’s not unusual to see some significant adjustments following a big surprise or a large disappointment in a given month. In my experience, what tends to happen when there have been one or two months with a surprisingly high labor report is the following report shows an underestimate that brings the running average back towards its normal trendline.

As you can see in the following chart, the NFP reports in January (312,000 new jobs) and February (304,000 new jobs) exceeded expectations by a wide margin. Normally, we would expect the data to subsequently “undershoot” expectations the next month, which happened with March’s report of 20,000 new jobs. Last month’s report was such an outlier that it is very likely the data will swing back up and beat expectations again.

Non-Farms Payroll (Blue) vs. Estimates (Gold).

The NFP report matters because if hiring is stronger than expected, retail and other consumer stocks should rise and inflation expectations will improve. If investors start to price in more future inflation from all the new wages hitting the economy, the yield on long-term Treasuries will pop back up. Short-term Treasury yields are only minimally affected by inflation, so a change like this could revert the yield curve into normal territory and clear the way for more gains in the stock market.

What to Watch

If history is our guide, it is likely that the labor report on April 5 will be better than expected as the data reverts closer to its long-term average. If jobs and wages are growing much faster than expected, the effect could be to lift long-term yields and create a better outlook for growth. However, if jobs are worse than expected for the second month in a row, the likely impact on equities could send prices much lower than the recent pause.

Earnings Won’t Matter – But Margins Will

Earnings reports for most stocks with a quarter that ended on March 31 will start to flow in the middle of April. The season really kicks off with the big bank reports that begin on April 14. This season’s reports are critical because it is one of the most important factors that could sink the market, regardless of what happens with the yield curve.

According to Zacks Investment Research, the average analyst expectation for first quarter earnings is that profits will contract by almost -4%. Estimates have been steadily declining for the last four months as investors prepare to see economic slowing show up in the profit reports.

It would be easy to brush off the poor earnings reports as a one-off because of the tax cut that took effect in 2018 and temporarily boosted bottom line performance. Tax-cuts only have that effect on profits for one reporting cycle, so this quarter’s reports are at a disadvantage of sorts. It’s hard to beat an inflated number, so negative growth this quarter shouldn’t be as much of a big deal. If analysts removed the effect of the tax cuts, this quarter might not look as bad–or would it?

I recommend that investors ignore the “earnings” or net profits portion of this quarter’s reports entirely. They will be distorted by the tax cuts and probably won’t reveal much insightful information about growth anyway. Instead, I recommend investors abbreviate the income statement this quarter and watch top-line (revenue or total sales) and operating margin.

Operating margin is calculated as the ratio of operating income divided by total revenue. Operating income is different than net income because it is the profit a company makes from revenue after the costs of production have been subtracted but before income tax or interest expense. Using this metric should help investors make a better comparison to last year.

I am a little concerned about operation margin because, even over the last year, there has been a significant deterioration in this measure. For example, in the following chart you can see how The Home Depot’s (HD) stock price rose last year with net margin (based on earnings) compared to the relatively flat trend of operating margin which excludes the short-term positive effects of the 2017 tax cut. The trend of HD’s fundamentals is characteristic of the stocks in the S&P 500 average.

What to Watch From Earnings

While the situation seems stacked against a positive surprise from an operating profit perspective, low expectations could be the source of positive surprises. Because most investors are already primed for a bad season for the bottom line, they are more likely to pay attention to operating margins. If operating margins are worse than expected, investors should expect a deeper correction in the market. However, if we are surprised at the operating level, I expect investors to ignore the bad news on the bottom line and bid stock prices higher.