The good news is that stocks are continuing to rally because the market is assuming the magic combination of continuing job growth, a trade truce, a friendly Federal Reserve, and a bottom on declining global growth will produce an expansion of earnings in 2020.
The bad news is that stock prices keep going up, but earnings estimates keep coming down over the last several months. Estimates for the fourth quarter of 2019 are now slightly negative, and while estimates are still up for the first and second quarters of 2020, they have been coming down fast.
S&P 500 earnings estimates
Fourth quarter: Down 0.6%
First quarter: Up 6.0%
Second Quarter: Up 7.2%
Source: Refinitiv
Of course, it is typical for analysts to overestimate earnings gains and see them come in lower as we get closer to the quarter that is being examined.
What is not typical is to have this happen with the markets at historic highs: The S&P rallied 12% in the fourth quarter on expectations earnings would be higher in 2020.
The trend for the companies reporting early for the fourth quarter — which includes notable disappointments from Federal Express, Micron, and Bed Bath & Beyond — is somewhat worrisome, said Nick Raich of the Earnings Scout.
“Given the EPS estimate revision trends of the early 4Q 2019 reporters, it is likely a vast majority of S&P 500 companies will be lowering their 2020 EPS estimates,” he said.
Prices up and earnings down means the multiple at which the market trades is climbing fast.
On Jan. 1, 2019, stocks were cheap at 13.9 times forward earnings for the S&P 500, well below the historic norm of roughly 16. On Jan. 1, 2020, it was at 18.0, and today it is at 18.4, the higher end of its range in the last 20 years.
S&P 500: Forward PEs getting pricey
Jan. 1 2019: 13.9
Jan. 1 2020: 18.0
Jan. 9 2020: 18.4
Source: Earnings Scout/Refinitiv
The obvious conclusion is that future stock gains will require the multiple to go even higher. “How much are you willing to pay?” Raich asks.
“It may not be euphoric pricing, but we are getting there,” he said. “Any negative factor that re-emerges is going to drop the market fast.”
What could that be? The Fed retreating from its neutral position, some signs the U.S. consumer is getting exhausted, or a return to tariff wars, Raich said.
The opposite problem — how to keep the market advancing with declining earnings — is just as urgent.
“The biggest problem is high expectations,” said Alec Young, Managing Director, Global Markets Research at FTSE Russell.
Young is not even sure that a strong December jobs report out Friday would be enough, given that this is already largely priced into the market. The current expectation is for a gain of 160,000 jobs.
“The bulls need a strong, clean jobs number, close to 200,000, wage growth 3% or a little higher,” to keep up the narrative of a strong consumer.