Fourth quarter earnings season is just getting started, and so far signs are pointing towards surprisingly good results. In particular, companies are seeing revenue growth exceed expectations by the widest margin in quite some time.
As of last week, roughly one-quarter of S&P 500 companies had reported earnings, and of those, a whopping 81% reported better than expected sales. 76% of these companies also reported better than expected earnings, but that’s not as big of a deal considering the ease with which earnings can be manipulated.
Generally speaking, investors care more about earnings than revenue because, after all, it’s not about how much you make, it’s about how much you keep. But for our purposes today, I want to focus mainly on revenues because a) they’re much more difficult to “fudge,” and b) they give us an indication of how the broader economy is doing.
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Before we examine revenues in more detail, it’s worth pointing out that many earnings figures for the 4th quarter will be distorted due to changes in the tax law. For example, most banks, such as Citigroup, experienced large one-time charges that had a major impact on earnings per share (EPS). In Citigroup’s case, including these charges result in a 4th quarter EPS loss of -$7.15, whereas excluding them results in an EPS gain of $1.28. For the most part, FactSet and other Wall Street analysts are opting to ignore these one-time charges in their EPS rollups.
Okay, back to revenues … Admittedly, it’s a bit difficult to predict how revenues will do overall, considering only a fourth of the S&P 500 has reported, but so far things are looking good. As mentioned, 81% of companies that have reported have beaten estimates. If this pace continues, it would mark the highest percentage of companies reporting revenues above estimates for a quarter, ever. The current record is 72%, set in Q2 2011 (FactSet).
Think about what this means for a moment. Investing is a game of expectations, and even though estimates of revenue growth rose from 5.7% to 6.7% during the fourth quarter, it turns out those estimates were still too low. Not only that, the widespread strength that we’re seeing is extending across sectors. It’s not just technology or cyclicals that are experiencing strong revenue growth, just about everyone is participating. That’s the perfect recipe for higher stock prices …
As a quick aside, notice in the chart above that every quarter of 2017 saw a higher than an average number of positive revenue surprises. To some extent, this should help explain why market performance in 2017 was so strong: expectations were consistently too low, which led to readjustments higher as actual results came out.
So far this quarter, every sector is reporting year-over-year growth in revenues, but three sectors are reporting double-digit revenue growth. Those sectors are Energy, Materials, and Technology. Revenue growth for both the Energy and Materials sectors leads the way at 17.7%, with Technology coming in at 11.4%.
It’s important to note that many of the companies experiencing the strongest revenue growth are international in scope, which reflects positively on the global economy. Case in point: Caterpillar. This manufacturing giant posted 4th quarter sales growth of 35%. Not only that, full-year sales broke a four-year streak of declining revenues. Caterpillar’s CFO, Brad Halverson recently said, “The global economy is the strongest it has been in several years, with nearly every region of the world expected to grow in 2018.”
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We’ve pointed this out before – that 2018 is likely to have the fewest number of economies in recession ever – but it’s still nice to hear validation from someone with boots on the ground who is actually doing business in these countries. Commentary from other management teams has echoed this sentiment.
With earnings season off to such a strong start, both on the revenue and earnings fronts, it begs the question: What should we expect for the remainder of 2018?
According to FactSet, analysts currently have 2018 earnings growth projected at 16.3%, with revenue growth of 6.0%. These are rosy estimates, but as we saw during 2017, analysts have actually been underestimating the ongoing improvement in conditions.
I don’t want to spend much time on these projections, as they’re exactly that – projections – but I do want to point out something obvious. If S&P 500 earnings do grow by 16.3% during 2018, then the market could conceivably deliver a 16.3% return with no multiple expansion. In other words, even if investor appetite for risk doesn’t change (investors are still willing to pay the same amount for worth of earnings), we could still see substantial double-digit returns this year.
Of course we’ve already captured about 7% of that just in the first few weeks of the year, but still … you get the point.
Moving on, if we take a look at leading economic indicators around the world, they seem to validate this notion of continued expansion and a larger economic pie.
Beginning with the US, here’s a look at the latest data for The Conference Board’s Leading Economic Index. The LEI rose 0.6% in December; this follows a 0.5% increase in November and a 1.3% increase in October.
The LEI for the US has been surging higher and still shows few signs of slowing. According to Ataman Ozyildirim, Director of Business Cycles and Growth Research at The Conference Board, gains among the leading indicators remain “widespread.”
As you would expect, the Coincident Economic Index moved higher as well (by 0.3%). These two indexes taken together suggest that the US economy remains on stable footing and is poised to continue improving in the months ahead. This, in turn, suggests that the risk of a recession in the first half of 2018 remains extremely low.
What about the rest of the world? Are they seeing the same strength in leading indicators that we’re seeing here in the States? The answer is yes, at least for the vast majority of countries.
As you can see, the latest figures suggest slightly weakening economies in Japan, Spain, and the UK Other than that, most countries are still showing signs of improvement. In order of GDP, the top three economies – the US, Euro Area, and China – saw increases in their LEIs of 0.6%, 0.7%, and 1.7%, respectively. This is part of the reason why the “Global” LEI has been doing so well.
Altogether, the data we’re seeing from 4th quarter earnings reports, as well as changes in respective LEIs, points toward continued strong economic growth. There’s no telling how long this period will last, but right now conditions remain supportive of higher stock prices.
The preceding content was an excerpt from Dow Theory Letters. To receive their daily updates and research, click here to subscribe. Matt is also the Chief Investment Strategist at Model Investing. For more information about algorithmic based portfolio management, click here.
