The most popular theories on stock valuation state that a share’s price is ultimately determined by the underlying company’s projected earnings potential. In order to decipher that potential and properly value a stock, analysts look at trends: Are the company’s earnings growing steadily every quarter? Or are they decreasing?
The reporting season for third quarter (Q3) 2019 corporate earnings has just started, and many in the markets begin the period in a melancholy mood. Data provider FactSet predicts that this quarter earnings will decline –4.6% year-over-year for the companies in the S&P 500. If this prediction comes to fruition, it will mark the first time the benchmark index has reported three straight quarters of year-over-year earnings declines since the second quarter of 2016. An earnings “recession” is often defined as just two straight quarters of negative growth. So why aren’t the markets acting more forcefully to such seemingly dismal data?
Well, 2018 was an especially good year for corporate profits, thanks in large part to companies benefiting from earlier tax breaks, thus making it difficult to maintain positive year-over-year growth in 2019. Analysts are aware that peak earnings in 2018 can produce anomalously poor data in 2019. However, there are other more worrisome factors that could depress earnings. FactSet has analyzed the conference call transcripts of S&P 500 companies that have reported earnings to the public so far (about 4% of the index). The chart below shows which factors were cited by company management during these interviews as negatively impacting their profits this quarter versus last quarter (Q2 2019). Weak foreign currencies have been the number one corporate concern. A subsequently stronger U.S. dollar makes American exports more expensive to international buyers potentially hurting revenues of multinational companies. The effect of higher tariffs also remains a concern, but it was cited less this quarter than last. Finally, increasing fears of a global growth slowdown are made clear in the gain in the number of companies that mention Europe and China as dragging down profits this quarter. If the aforementioned factors do continue, then there could be more of a market reaction to reduced profits, and this earnings recession may start to feel more “real".