After surging in 2018, after-tax earnings have softened.
Earnings season begins in earnest on Tuesday, as JPMorgan Chase led the pack of banks reporting third-quarter results, and the numbers aren’t likely to be pretty. Strategists are saying profits for the Standard & Poor’s 500 SPX, +1.13% stock index will be down about 4% — not enough to push the U.S. into a recession, but enough to keep questions alive about whether the economy will generate much growth.
So what’s going to happen, and what should small investors do about it? That’s the question up and down Wall Street this week.
First off, a quick note on Wall Street and its ways.
If history is prologue, earnings will slightly beat current expectations — the typical pattern is that estimates for a given quarter or year start out too high, get revised lower until they are a little too low right before the news hits, and then the actual news is slightly better.
A grain of salt
The corollary to this is that investors should also take projections that corporate profits will rise 10% in 2020 with a grain of salt, CFRA Research strategist Sam Stovall says.
“Analysts are usually too optimistic in year-ahead estimates,” Stovall said in an email. Since 2000, “analysts overestimate [the following year’s profit gains] by an average of 5.2%”
JPMorgan’s JPM, +4.04% results were pretty good — an 8% profit gain to $9.08 billion, or $2.68 a share, beating forecasts by 23 cents a share, that made the stock climb 2% in early trading. But nearly flat loan growth keeps prospects muted: CEO Jamie Dimon said “healthy” consumer finances are being partly offset by “weakening business sentiment and investment” — meaning that he sees the same economy everyone else does.
The outlook is the same as it has been — growth is slowing, but a recession isn’t in view yet, notwithstanding some outlier pundits who think the recent manufacturing slowdown has too much momentum not to spill over into the broader economy.
We’ve all been though the speculation that an “earnings recession” — two straight quarters of year-over-year earnings declines — will lead to a real recession, but so far earnings have stayed barely above 2018 and forecasts call for them to move back into positive territory by the fourth quarter.
What that means is the subject of a disagreement this week between Goldman Sachs and Morgan Stanley, two of Wall Street’s biggest and most respected investment banks.
Goldman pushes growth
Goldman argues that the slow-but-fairly-steady growth of the economy means that investors should be focused on growth stocks, in information technology and elsewhere.
Stocks with higher profit growth rates tend to be more expensive — that is, to trade at higher multiples of their projected (in this case, 2020) profits — but growth stocks have risen 77 percentage points more than value stocks throughout the long recovery from 2008’s financial crisis.
The reason is really simple, Goldman strategists led by David Kostin say: In a slow-growth economy, companies that can boost profits rapidly are rare, so people pay up for them.
“During the last 35 years, stable growth stocks have outperformed during times of economic policy uncertainty,” Kostin’s team writes. “If uncertainty remains elevated ahead of next year’s U.S. elections, investors will likely continue to reward the stocks with the most stable historical earnings growth.” .
The trick of betting on growth is that high valuations can be volatile, Kostin’s team says. As the economy slows, from last year’s 2.9% growth rate to the 2.3% Goldman predicts for this year and 2.1% next year, markets tend to beat up companies whose earnings growth is more volatile.
That leads Goldman to push its clients now toward growth companies that have been more stable over time, even though they are 23% more expensive, as a group, than the market, Kostin said. In tech, that points Goldman toward Alphabet GOOG, +2.05% and a raft of payment-processing companies, led by Fiserv FISV, +0.65% and Amdocs DOX, +0.86% .
Morgan Stanley’s caution
That’s not how it looks to Morgan Stanley’s Michael Wilson, though. “Overpaying for growth remains the biggest risk,” he wrote on Monday.
Wilson’s take on the economy is that last year’s near-3% growth was a mirage purchased by the 2017 tax cut. The gusher of money caused small excesses, or bubbles, in corporate investment and inventory building that needed to be offset by slower growth this year, he said, a pattern that shows up especially in slow inventory growth the last two quarters.
He thinks this payback is not near its end.
This means profit growth is likely to be near zero for the next 12 months, Wilson said. And that means the premium people have been paying for growth is untenable, he argues.
That leads Wilson to a different list of stock picks than Kostin’s.
His top pick in tech is Microsoft MSFT, +1.38% , a stock this column called (correctly, for now) the best of the FAANG stocks in July 2018 for much the same reasons — modest price combined with a secular opportunity in corporate America’s shift to cloud-based computing.
For most small investors, the game is more about selecting mutual funds than stocks. And even there, the signals are mixed, since the best performing sector funds this year are in technology, which is a growth-dominated area, and real estate, a value bastion.
And for most investors, it means looking past the immediate problems of right now. This week’s trade disputes and earnings reports will be in the rearview mirror soon enough.