July 15

Earnings, we don’t need no stinking earnings

We don't need no stinkingBy David Nelson, CFA CMT

Stocks ended the week at another all-time high in front of an earnings season that even bulls concede will be challenged. The current script pits analysts who continue to cut numbers with traders and investors chanting, “earnings, we don’t need no stinking earnings.” 

Of course, most companies will report headline numbers that beat consensus. How could we not? Analysts have been tripping over themselves taking a scalpel to earnings estimates for the last 9 months. It’s safe to say we’re going to step over a lowered bar, but will that really give us the big picture.

Spx breakout july 19

All the usual suspects are in play. The ongoing trade war with China, and a 2020 election landscape that will likely have investors bouncing from one sector to the next as candidates go after corporate America. Goldman’s data dump this week puts expectations about 2% below last year with six of 11 sectors declining.

S&P Earnings estimates have declined for the last 9 months
9 month decline

Are Rising Labor Costs Bad?

Here’s where the data starts to get interesting. On the heels of strong labor reports and an unemployment rate falling to 3.7% margins are under pressure in part due to rising labor costs. Companies are being forced to pay up for qualified workers. Goldman puts the contraction at about 89 basis points.

So why then the disconnect between earnings estimates and stocks? In the long run stocks follow earnings. Isn’t that investing 101? Data and performance aren’t necessarily linear but in fact may only explain part of the story.

Certainly, the Fed’s about face morphing from hawk to dove is a big part of the picture. A lower risk-free rate implies higher valuations as multiples expand sometimes even in the face of earnings declines. While it’s increasingly unlikely the Fed will cut by 50 bps it’s nearly a lock, we get 25. Nearly 100% of economists believe the Fed will cut rates this month. We can debate the long-term wisdom of a rate cut another time but in the short run it’s a clear positive. I think it’s safe to say much of the rally this year is the Fed’s change in rhetoric and soon policy.

Tightest Labor Market in the last 50 Years.

But why so little concern on the margin compression. Goldman’s Ben Snider and David Kostin believe this is the tightest labor market in the last 50 years. Rising labor costs haven’t been a problem for most of the last decade and suddenly on the heels of consistent strong labor reports U.S. companies are forced to pay up for qualified workers.  I’m speculating for sure, but I believe labor costs rising naturally in reaction to a robust economy is looked at more favorably than rising costs for commodities, transportation, marketing, legal, R&D or pay hikes mandated by Congress.

In the last couple of years Amazon (AMZN), Target (TGT), Walmart (WMT) and others were forced to raise their minimum wage. You can bet the CEOs didn’t suddenly decide they wanted to be more generous. Nothing drives wage gains better than a strong economy that gives workers a choice.

Earnings season kicks off this week with Citigroup (C) Monday and Goldman (GS) Johnson & Johnson (JNJ) and JPMorgan (JPM) the following day. For the next few weeks CEOs are going to have a chance to make their case that the recent price gains are justified. As usual the market will act as judge, jury and executioner.

*At the time of this article some funds managed by David were long AMZN, TGT and WMT