Sweet (Earnings Expectations) Dreams Are Made Of This
ConvergEx's monthly review of analysts' revenue expectations for the 30 companies in the Dow finds a ray of sunshine (let's call them 'sweet dreams') to counter the current humdrum market action. First, the 'good' news: analysts expect the current quarter to post some of the best top line growth in over 2 years. The 'meh' news: that’s still only a 2.5% comp to last year, and 2.9% excluding financials. Still, that is better than the 0.3-0.5% growth of Q1 2014. That acceleration, such as it is, continues into Q3 2014, where analysts have revenue growth pegged at 3.9%. The 'bad' news: brokerage analysts have been spectacularly wrong in forecasting revenues of late. In Q1 2014 the Street expected 4-5% growth in May of last year, only to whittle those numbers down month after month and still prove too optimistic on earnings day. Still, things might work out this time and Q2 will actually see a rebound. At current valuation levels, the bulls better hope they do.
Via ConvergEx's Nick Colas,
There is an old joke on Wall Street: “What’s the difference between a bond and a bond trader?” The answer: “Bonds mature.” Yes, the fixed income group in a given brokerage firm or money manager may house more bon vivants than Soho House during NY Fashion Week, but scratch a bond guy/gal and you’ll quickly find the pessimist lurking within. That’s because this group knows that over the long run the best they can do is get their money back from a bond, plus interest. Their upside is the issuer just keeps their promise. Your downside is they don’t. The chance for a surprise windfall is zero.
The real optimists of Wall Street sit on the equity desk. They may play the bear from time to time, just to show they can. But stock investing is ultimately about how things can go right in pleasant and unexpected ways. The core argument for owning equities always ends with “And they lived happily ever after.” Even the turmoil of the last 20 years hasn’t shifted that foundation. Over the very long term, equities beat other asset classes because you are long human innovation when you own a portfolio of stocks. And there’s no more optimistic perspective than believing in your fellow man and woman to deliver the goods and generate positive returns on society’s capital.
Silver screen vixen Mae West was famous for saying “Too much of a good thing can be wonderful”, but she probably never ran across a bulled up Wall Street stock analyst. And if she did, they probably didn’t talk stocks. Over the last few years we’ve been tracking this group’s expectations for revenue growth at the 30 companies of the Dow Jones Industrial Average. The original idea here was to follow the nascent global economic recovery as it filtered through corporate financial results in the period after the Financial Crisis. That story played out pretty well in 2009 and 2010, as revenue growth ran a healthy 10-15% year over year. It was a happy, sunny, simple time.
Since then, however, the storyline has shifted to a darker tone where optimism is a great travelling companion but it can’t read a map or figure out the rental car radio. We can summarize this transition by looking at the recently completed and reported Q1 2014:
In May of last year, the Wall Street brokerage analysts that cover the Dow stocks were very optimistic on Q1’s top line growth. Their consensus perspective was that 4-5% year over year growth was achievable.
In the following months, they gradually lost their courage. In April 2014, with these companies about to report, their collective wisdom held that revenue growth would average 1%.
They still missed the mark; average revenue growth came in at 0.3% for the Dow names, and 0.5% for the non-financial names. On the bright side, at least it wasn’t negative, as it has been off and on since 2012.
In short, optimism certainly has a place in equities, as I have described. But since the end of the snap-back in corporate revenues in 2010, we have seen nothing but the same pattern noted in the points about Q1. Analysts start out with high numbers and slowly reduce them to something more realistic as the day of reckoning arrives. Another old Wall Street aphorism: “Never hire analysts. In a bull market you don’t need them, and in a bear market they’ll kill you.”
Which brings us to the current day. U.S. equities are still up on the year (at least large cap stocks, anyway). First quarter GDP was just as dismal as first quarter Dow stock revenue gains. And the map light of optimism over future quarters still shines reasonably bright on domestic equities. We can see this in the analysts’ revenue expectations for Q2 and Q3 2014 (see associated tables and charts immediately after this note):
The current consensus for Q2 top line growth is 2.5%, and 2.9% once you exclude the financial names in the Dow. Despite a no-growth Q1, Street analysts have not really pared their Q2 revenue expectations since late last year. The ex-financials estimate of 2.9% is actually an uptick – the first since last October. Analysts clearly believe in the weather-related weakness explanation for sloppy Q1 sales. The sun will (hopefully) come out tomorrow. Bet your bottom dollar…
Analysts have also grown bolder about their Q3 expectations, which are now up to 3.9% as an average comp for the Dow 30 companies to last year. This reverses a slow grind lower, which started at a 5% comp expectation in November 2013 and ended at a 3.6% expected improvement in top line growth last month.
It is still a little early to handicap Q4’s trends, but analysts are out with a 3.0% revenue comparison to last year’s fourth quarter. Not much change over the last three months here.
Make no mistake – this is the single most important factor to consider when pondering the fundamental direction of U.S. stocks over the remainder of the year. That’s because revenue growth fulfills the reason equities are worth owning. Better sales drive better earnings and better returns on capital. Should you own stocks here because analysts are optimistic about the balance of the year? No. The track record here is spotty at best.
The logic, however, that guides analysts to forecast a better Q2 and second half of 2014 is very much the same as that which defines the future direction of stock prices. Without sales growth, equities just keep earning the same basic returns as they have in recent years. What do you call a security where the cash flows are fixed? Yes, a bond. Only it is a bond that never matures. And you probably don’t want that.
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