INSIGHTS

On February 26, 2018

AAM Viewpoints – An Earnings Resurgence

Be careful what you wish for. Many market commentators, us included, have been highlighting the long absence (about 15 months) of a 3% or greater setback for the S&P 500. The thesis was simple – we need a pullback to occur to help the market regroup, pull out some of the excesses and then hopefully move on to new highs. Then it occurs and a bit of an investor panic ensues. In addition, the financial media then tries to play its version of “Pin the Tail on the Donkey” to try and come up with the reason, or reasons, for the selloff. Some of the catalysts cited included higher interest rates, increasing inflation, stretched valuations, a new FOMC (Federal Open Market Committee) chair, faulty investment products tied to the VIX Index and so on. These may have been the cause, either individually or combined, but all of these factors were pretty well known prior to the selloff. While these discussions of causation fill hours of screen time, we don’t feel they really make us better investors. As quantitative analysts we prescribe to the concept of reversion to the mean for many long-term trends, and quite simply in this situation we were way overdue for a pullback. Given this we do believe it is feasible that this simple concept – reversion to the mean – and this alone, was the driver. However, it is impossible to know for sure. Regardless, we continue to believe that this bull market will propel higher, and we feel the primary driving forces will be a continued rebound in corporate revenues and earnings. Therefore, let’s focus some attention on those.

At least once a year we like to emphasize revenue and earnings trends in our commentary as we truly believe these are the long-term “magic elixir” for equity prices. Obviously these can’t be viewed in a vacuum but without positive revenue and earnings trends, both on an absolute and relative basis, it would be tough for equities to move higher over long periods. In 2015 we opined that revenue needed to awaken – it did. In 2016 we suggested earnings were bottoming – they did. In 2017 we observed that earnings were back in the driver’s seat and we believe that is why the equity markets were able to go on an unabated 15-month run to another all-time high in late January of 2018. Now we would like to suggest that earnings are undergoing a resurgence that should be enhanced by the new lower tax code, but it really starts with revenues, or the top line.

This bull market is approaching its ninth anniversary (3/9/2018) and over that span the S&P 500 has averaged (on a market-cap weighted basis) year-over-year (YOY) revenue growth of 2.64%. For this quarter (87% of reports are in) we currently sit at 7.53% with 86.51% of the constituents growing revenue YOY which is the highest level in 12 years (the average is 68.63%). However, as strong as those numbers are, we prefer to look at the median growth of revenues YOY as large-cap companies may cause distortions in either direction. The graph below summarizes median YOY revenue growth for the S&P 500 over the last three years (12 quarters).

Source: AAM

As you can see there was a slowdown for three consecutive quarters and then a very nice acceleration over the next eight quarters culminating in a nice jump to 8% in the current reporting period (87% of reports are in). Some would argue a portion of this gain is attributable to a weak U.S. dollar as almost half of the S&P 500’s revenue is derived internationally. Given this we believe it would be fair to shave 2% off of revenue growth in the current quarter to get closer to an organic growth rate and quell the pessimists. That still provides us a solid print of 6% and thus it should be noted we would need to make a similar adjustment when the dollar gains strength and revenues are negatively impacted. However, we think this is far from being just a weak U.S. dollar story as the median revenue growth for mid-cap stocks is also at 8% YOY and small-caps stocks are at 9%. Both of these are more U.S. dependent so this clearly illustrates a very robust organic revenue growth climate for U.S. corporations. This is translating into a very robust earnings growth environment that has the S&P 500 currently growing its YOY earnings at twice its long-term average. Going forward we believe the organic trend that is in place will only be enhanced by the new tax code. This should allow earnings to continue to rebound from the earnings recession, which spanned six quarters in 2015 and 2016, and help drive the S&P 500 toward the 3100 level by year end.

Regardless of our optimistic outlook it doesn’t imply that there won’t be bumps and bruises, and volatility will surely rise from the extremely low levels that have seen us hover at readings that are about half of their long-term averages. Specifically, the bump that occurred from 1/26/2018 through 2/8/2018 which saw the S&P 500 shed 10.16% of its value was a big jolt, especially given it occurred in just 13 calendar days. However, to put it in context, it is well below the 50-year average for calendar year intra-year drawdowns which sits at 14.33%, and for now looks like business as usual to us. Markets always seem to go down faster than they go up; thus it will likely take some time to work through this current sell-off. Yet, as stated earlier, we still believe the current bull market for equities is alive, and if not currently well, slowly getting better. Given this we continue to favor growth stocks over value, small and mid-cap over large-cap and international over domestic as we look for equities to make fresh new highs later in 2018.

CRN: 2018-0205-6401 R