It is hard to believe that we are already closing the first quarter, and getting ready for the Q1 2018 earnings season. It is also hard to believe that Winter may be finally transitioning to Spring. Sitting here in Philadelphia, we have scarcely had any hint of upcoming warmth as it was a very cold and stormy March—battered by Nor’easter after Nor’easter.
The market also seems like it was hit by several storms. Wave after wave of market impacting news has washed over the market causing this quarter to be the first quarter since 2015 where the market lost ground. The news coming out in March primarily hit the market when companies were not reporting. This magnified reports about Trade Wars, Facebook privacy issues, and the Tesla cash crunch.
As I walked the dog this morning, I saw daffodils on the river trail, buds on the trees and birds singing. These harbingers of Spring could finally bring relief to those of us who are weary of winter. Similarly, positive earnings surprises, increased corporate guidance, and raised estimates could bring relief to the weary market participants, and allow them to focus on the core fundamentals of the market which remain very strong. Perhaps I am stretching the analogy too far?
Four Questions to Ask Yourself for Q1 2018 Earnings Season
When Investors look at the upcoming season, people are going to look to answer four questions:
- Earnings expectations—they are sky high for companies entering this season. The yardstick that each company has to jump over has been raised to a much higher difficulty level. Can companies keep exceeding the expectations?
- Price impacts of earnings surprises—The last few quarters have ushered in a paradox. Oftentimes, companies that report blockbuster earnings mysteriously have their stock price hammered. How will the market treat strong earnings?
- Guidance for Q2—One of the striking elements in the last couple of months is how confident companies have been. They have been raising expectations by altering their corporate guidance upwards. Will this continue?
- Market Volatility—The Vix has raised its ugly head last month. In a time period where companies are reporting, is volatility exacerbated or does it settle down?
Let’s look at each of these in turn.
Q1 2018 Earnings Expectations
Q4 Earnings season ended in Mid-Feb was another great quarter. Read the wrap up here. Earnings were very strong. Factset reported that Earnings grew by almost 15% with all sectors reporting growth. More importantly, revenue grew at double digit growth which is very healthy.
All of this good news propelled analysts to increase their estimates for Q1 2018 earnings season. In fact, 3 months ago, analysts were expecting 11.4% growth. This number now sits at 17.3%. This sets a very high bar for the companies to jump over. Over ¾’s of all companies in the S&P 500 beat earnings in the prior quarter. If this continue in Q1, that would mean an incredible quarter.
With all of this good news, you would assume stock prices rocketed upwards when company after company reported a positive earnings surprise. Remember they were beating estimates that the analysts had already raised. Last quarter, though, this was not the case. The price impact of positive earnings surprise was muted. The quarter as a whole was down for the first time since 2015, and immediate price impact was negative for many positive earnings surprises.
That’s right! In a quarter where companies beat earnings, raised guidance and had analysts raised their estimates, stock prices declined. There are two main reasons for this:
Macro impacts: Whether is was the stirring up of a trade war (always a negative for the market) or fears of increased interest rates or the tech sector facing increased data privacy regulations there were a constant stream of bad external news impacting the market.
Buy the rumour, sell the news. This has been an increased phenomenon during the last few earnings seasons. Investors bid up stocks that look like they will have a positive earnings surprise, and then sell it the minute that the good news is released. Given the high valuations in the stock market, this makes some sense from a short term trader mentality. From a longer term investor’s perspective though, a positive earnings report is the START of a virtuous cycle. Earnings surprises come in bunches, so a positive surprise this quarter bodes well for a positive earnings surprise in future quarters. Additionally, a positive surprise starts a cycle that leads to increased corporate guidance, and then analysts taking their future quarters’ estimate up. These should all lead to positive stock price momentum.
Look at Micron stock chart below. The green arrow indicates the positive surprise, the price dips on the news, and then as the market reacts to downstream good news (analyst estimate raises), the stock price resumes its upwards trajectory.
This pattern is repeated each quarter, and almost becomes predictable.
The question now becomes will the market begin to treat positive earnings surprises in the more traditional way. Good surprises are rewarded with positive price impacts. Now that the market has entered a corrections, valuations are not as extended. That could bode well for this quarters’ earnings surprises.
Corporations Forward Looking Guidance—Will it continue to be strong?
Normally, companies try to alert analysts when their results may underperform expectations. This enables analysts to get ahead of the curve, reduce their estimates, and look forward to nailing their estimates. In fact, usually 2 to 3 times more companies LOWER their guidance than raise their guidance. In the current quarter though, this has not been the case. In fact, just slightly more companies have raised their guidance than lowered their guidance.
This represents a real change in corporate confidence in the future. Companies typically like to underpromise and outperform. If they now feel that they can raise expectations and still beat them, then that is a really good indication of future earnings season. So keep a careful eye on corporate guidance as we proceed through the season.
Market Volatility—Does it subside with the advent of earnings season
In the span of weeks between the end of Q4 earnings season and the start of Q1 2018 earnings season, we were hit by external news that whipsawed the markets. This trend was made worse by the fact that there has been so little volatility in the prior years. Investors were thrown out of their safe, warm cocoons and forced to confront sizeable price drops for the first time in over a year.
If the Q1 2018 earnings season is as strong as the Q4 2017 season, will this be a palliative that calms the market down. Will investors now pay attention to company fundamentals and the positive outlook and settle down?
All signs are pointing to a fantastic earnings season. The news emanating from the market should be extremely good for stocks. Much like Spring has begun to show its first green shoots, will the advent of Q2 earnings season usher away some of the dark storm clouds and refocus investors on the positive fundamental news that companies are beating earnings estimates and growing their earnings at a healthy pace.
I certainly am looking for a great Spring, and a good Q2 in the market.