One of the more peculiar features of the last financial crisis, is that it took place at such a breakneck pace, most corporations were unprepared for the carnage that would ensue, and few companies even had the time to cut profit guidance into the Lehman abyss.
This time, things are different.
As we reported last week, Factset found that after a spectacular Q1 and Q2 earnings season, which blew away expectations, corporations have turned decidedly sour on their own prospects, and as they head into the start of Q3 earnings season, 76% (74 out of 98) of companies have issued negative EPS guidance, which is not only above the five-year average of 71%, but if 76% is the final percentage for the quarter; it would also mark the highest percentage of S&P 500 companies issuing negative EPS guidance for a quarter since Q1 2016 (79%).
The Factset report promptly went viral across Wall Street desks, which after the earnings bonanza in the past 2 quarters have been especially sensitive to any suggestion that the dreaded "peak earnings" moment in the S&P500 is upon us.
To be sure, so far such worries have proven to be unfounded: In Q1, earnings soared 24% Y/Y; a number which was also repeated in the second quarter. And while most sellside estimates predict another blowout quarter in Q3, any time there is a major divergence between company guidance and analyst optimism, the market immediately pays attention... and in this case the divergence between company and analyst outlooks is remarkable.
And it's not just Factset: according to Bloomberg, led by high-profile warnings from Netflix and Applied Materials, the number of S&P 500 companies saying profits will trail analyst estimates outnumbered those saying they’ll beat them by a ratio of 8-to-1 in the third quarter. That’s the most in Bloomberg data which goes back to 2010.
While several conclusions are possible, not all are concerning; one is them that analysts - who saw their predictions beat at record rates in the first half - got tired of being wrong and lifted estimates to unrealistic heights. Or, as Bloomberg notes, "it could be that companies, which hate merely to match estimates, are making room for the quarterly ritual in which they beat every forecast by a penny."
However, while it possible that there is perfectly innocent explanation, for skeptics looking for evidence income growth is peaking, a more ominous take-away has emerged, and comes as a consequence of global trade at a time when everything from rising costs to weakening overseas demand threaten to damp growth, according to Citi's equity strategist, Tobias Levkovich.
"Given ebullient investor sentiment, we do not think there is much room for companies to disappoint without taking a hefty toll on share prices. Notably stronger dollar and higher interest rates plus some softness in emerging economies all intimate the potential for misses."
He's right, because with companies expected to earn $42.11 a share in the third quarter - which would be a new quarterly record - and with valuations (especially for the median company) already at nosebleed levels, the margin of error is getting thin. Consider that among the 19 S&P 500 companies that have reported results early this season, all but two exceeded profit estimates: their stock dropped an average 2.8% in first-day reactions.
Meanwhile, there is another reason why everyone's attention is focused on earnings: with everything else in the world on edge, amid growing fears over higher rates, populist politics, escalating geopolitcal conflicts and outright trade war, strong and rising US earnings have been the backbone behind the S&P's record price. So any sign that this is changing is an especially acute threat. Miller Tabak's Matt Maley explained it best:
"Strong earnings have been the most important factor that has enabled the stock market to ignore the headwinds it has faced this year. If the projection for future earnings suddenly become less bullish, it could/should be enough to upset the balance between the bullish & bearish macro factors that are facing the markets right now."
What is troubling is that as sellside analyst projections have remained bubbly, management sentiment slumped in the second quarter according to UBS. Such negative guidance language is likely to accelerate during this reporting season given the uncertainty around trade talks between the U.S. and China, said Keith Parker, the firm’s head of U.S. equity strategy.
The question in such as a situation, as usual, is what do management teams know that analysts don't (a rather simple answer is "everything") and why are they turning so pessimistic (this should be self-explanatory). What didn't help is that those analysts who were cautious on company earnings in Q2, ended up looking like fools. Bolstered by tax cuts and a strengthening economy, more than 80% of S&P 500 companies delivered better-than-expected profits during last reporting season, a record high rate. Q2 earnings were so strong that they topped forecasts by a whopping 5.2%.
However, that record pace of beats is unlikely to continue, said QMA chief investment strategist Ed Keon,
"You’re going to go to a slower trajectory. You’ll see the second quarter will turn out to be the peak in terms of growth rates."
The ominous message sent by management teams who are slashing guidance at a near record pace, and which the market is so far ignoring, is that Keon is right.