With the market surging and expectations high, I want to look at the actual corporate earnings numbers for 2017. Of course, it is early in the season to do any definitive analysis. But we can certainly set some context, which will be particularly useful for this year.
As of the start of the year, the expected earnings growth rate for the S&P 500 for the fourth quarter of 2017 was just over 10 percent, with all 11 sectors of the market expected to make more money. This was a very healthy growth rate. If we got there, it would go some way to justifying current valuations and expectations.
It seemed reasonable. With 4 percent of companies in the S&P 500 reporting as of January 5, over three-quarters reported positive earnings surprises, while almost all (94 percent) reported sales surprises. Again, early days, but a really good start. You might reasonably expect a blowout earnings season, justifying high stock valuations and the recent surge.
Fast forward to last Friday, though, and the news looks very different. With 11 percent of companies reporting, just over two-thirds are reporting positive earnings surprises, while the positive sales surprises are down to 85 percent. This is still good, but a big drop from where we were two weeks ago.
It gets worse
The expected earnings growth rate for the fourth quarter dropped from about 10 percent to a decline of 0.2 percent—from a big gain to a drop. This is a huge swing, and one that at face value should scare the heck out of investors. Nonetheless, the market keeps rising. What is going on?
Let’s take this in two stages. First, let’s see where the decline came from, and then we’ll look at what it means for the future.
Where did the decline come from?
All of the decline in earnings, a total of more than $28 billion, came from the financial sector and mainly from a couple of large companies. Citicorp was the biggest, accounting for $21 billion. American Express and Goldman Sachs both contributed as well, with quarterly earnings swinging from strong gains to meaningful losses. Why?
In all of these cases, you can ascribe the losses to the new tax law and how it affects the company balance sheets. Although each case is different, in general, the new tax law has resulted in a need to revalue tax-related assets. The earnings declines don’t reflect the business falling off a cliff but simply recognize that tax changes have made some existing assets worth less. The earnings reflect that revaluation.
What does it mean for the future?
Looking forward, however, that same new tax law is expected to substantially enhance earnings as companies pay less in 2018. Indeed, despite the drawdown in the last quarter of 2017, analysts are expecting double-digit earnings growth in all four quarters of 2018. Plus, the expected earnings growth rate for 2018 has increased from 12.3 percent to 18.6 percent. That makes current stock prices seem a lot more reasonable and, as such, has helped fuel the rally so far this year.
Just as the 2017 numbers are misleadingly low, however, the 2018 numbers are misleadingly high. That growth rate is off 2017 numbers that are, as we noted, taken down by the tax law.
Look beyond the headlines
As you read the headlines over the next couple of weeks, keep in mind how much of the decline in earnings is tax driven—and don’t get too depressed. In 2018, as you read about how fast earnings are growing, don’t get too excited. Both the bad news and the good news are real but need to be understood in context.
Brad McMillan is the chief investment officer at Commonwealth Financial Network, the nation’s largest privately held independent broker/dealer-RIA. He is the primary spokesperson for Commonwealth’s investment divisions. This post originally appeared on The Independent Market Observer, a daily blog authored by Brad McMillan. Forward-looking statements are based on our reasonable expectations and are not guaranteed. Diversification does not assure a profit or protect against loss in declining markets. There is no guarantee that any objective or goal will be achieved. All indices are unmanaged and investors cannot actually invest directly into an index. Unlike investments, indices do not incur management fees, charges, or expenses. Past performance is not indicative of future results.