Earnings are the biggest driver of stock prices and valuation. This doesn’t imply companies are the sole determinants of their stock prices. Issues like geopolitics, the weather, and the economy get filed under systematic risk factors.
These are the factors that are talked about in the news so much because they apply to all companies. It’s important to have a balance between reviewing the macroeconomic conditions and the company’s specific fundamentals. If you focus too much on the macro issues, you might miss out on companies that are doing well in spite of the macro challenges.
Trends and headline issues are meant as guidelines, not to be the only aspect you use when investing. On the other hand, if you only focus on the companies you follow, you might miss out on mega trends that companies can’t overcome. We’re not talking about making economic predictions; we’re referring to fundamental stock pickers ignoring the obvious economic issues that are already happening. Investing is all about having the right mindset and the best process.
Since earnings are so important, it’s critical to look at the estimates. Even though SPP 500 firms in Q2 had 10.3 percent year over year earnings growth and Q4 is expected to see 11.1 percent growth, Q3 earnings expectations have crashed. As you can see in the FactSet charts, there has been a decline in expectations which means now Q3 growth is only expected to be 4.2 percent. That’s a sharp turn from the positive results seen in the first half where expectations weren’t so negative, and they were beaten easily.
You would think if earnings expectations were falling, we’d also be seeing a lot of negative pre-announcements. However, pre-announcements have been record breaking on the positive side. As you can see from the chart, there have been 54 positive sales pre-announcements which is the highest number since FactSet started tracking this in 2006.
The obvious question is how earnings expectations have fallen at a time when firms have stated that business is great. The answer might be Hurricanes Irma and Harvey. Because the hurricanes happened when results weren’t being updated, we are in the dark on how businesses were affected. It appears that analysts are expecting the worst since the consensus has been lowered by so much. Six firms have provided updates since August 25th which is when Harvey hit Houston. Three firms mentioned the hurricanes, two of which said it was too early to tell the extent of the impacts. It’s possible that analysts are either underestimating or overestimating the affects.
The big trend this quarter has been declining Q3 earnings expectations possibly because of the hurricanes. Interestingly, the stock market is ignoring this weakness as it continues to hit record highs. Bullish investors better hope this is a one time event caused by the weather because if it’s not, stocks have a lot of room to fall as 2018 estimates will drop. The aspect to watch out for is companies blaming secular weakness on the weather. On the positive side, it’s possible analysts’ fear of the unknown caused them to drop their estimates too much which means upside surprises are coming.
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