C.J. Lawrence Weekly – 2018 Earnings Estimates May Be Too Low

Third quarter earnings season kicked off last week with good reports from most of the big banks. JP Morgan Chase, Citigroup, and Bank of America all topped analysts’ top and bottom line forecasts. Despite the “beats”, the stocks of those companies experienced muted responses to their reports. It appears there may have been some selling of the news to counter the incremental enthusiasm for rising earnings and constructive outlooks. As we suggested in last week’s note, the Financials sector is projected to deliver solid double-digit earnings growth in 2018, and looks attractive on a relative valuation basis.

Earnings season provides a good opportunity to gauge corporate financial progress versus expectations and to revisit forecasts. The 3Q17 results may be a bit noisy due to the recent hurricanes but early indications suggest that corporate profits are on track. But with equity valuations close to the top of most historical ranges (discussed in our “Rule of 20” note on Sept 18, 2017) increased attention is being paid to the macro outlook and the rate of growth in corporate earnings, and what is being incorporated into those earning forecasts. The seemingly daily debate centers around whether the prospects for corporate tax reform and/or accelerating economic growth are baked into analyst projections. Our view is that neither is fully discounted, representing potential upside to current estimates.

On October 31 of 2016 the benchmark U.S 30-year treasury bond yield and the benchmark US 10-year treasury bond yield stood at 2.58% and 1.83% respectively. On Friday, they closed at 2.81% and 2.28%. While not dramatic, the upward moves in rates over the past twelve months suggest, in part, that the bond market believes there are greater prospects for inflation and growth than were expected last October. Yet, over the same period, analyst bottoms-up expectations for 2017 and 2018 S&P 500 earnings per share, as measured by FactSet, declined slightly. At the same time, our rough calculation of a move to even a 25% corporate tax rate, if achieved, could add an additional 9% to the index’s 2018 earnings per share. We’ll leave it to the policy experts to project if/when corporate tax reform becomes a reality, but if it does, and economic growth continues to accelerate, corporate earnings estimates will be revised upwards, putting a dent in the bear’s over-valued market argument.

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