Death Threats & Other Market Signals

If you worked as a sell side analyst in the 1990s, you probably heard a similar message on your work voicemail at some point (and probably more than once).  I covered the auto stocks back then, and many workers in that industry felt Wall Street was forcing management to close U.S. factories in order to satisfy our financial expectations.  As one analyst that got quoted in their local papers, they figured it was partially my fault.  The fear they hoped their message would elicit (and it certainly did) was payback for the fear they felt over losing their jobs.  Fair enough – I never took these calls personally. 

It wasn’t just me – tech sector analysts got their share of public ill-will during and after the tech bubble in the 1990s. Downgrade a favorite high flier while markets were stilling rising?  Or stay on the bus too long after the bubble began to burst?  You were pretty sure to walk into the office and have your share of 2am voicemails forecasting your impending demise. 

I haven’t heard such stories from friends in the business in many years, however, probably for the simple reason that sell-side analysts don’t really have the public profile they used to enjoy.  Higher sector correlations to the market and the trend to passive investing have limited their impact on market psychology.  In their place, Fed-watching macro analysts have taken their turn in the spotlight.

Equity market price action since the U.S. election last week shows the fortunes of the single-stock analyst may be about to change.  Over the last 5 days, Large cap Industrial stocks are up 8.6%, Health care equities are +5.7% and Financials are 14% higher.  The S&P 500 is only up 3.8% over the same timeframe.  Investors are trying to pick winners and losers again – an interest we haven’t seen in a long time. 

Stocks always move ahead of actual changes in their fundamentals, so these gains are simply the market’s best guess about the future earnings impact of a Trump presidency.  Changes in corporate and personal tax rates, infrastructure investment, alterations to the regulatory structures around Financial Services and Health Care…  At this point markets are enjoying the anticipatory sizzle of the steak that is making its way to our table.

To get a sense of just how much upside these sectors – and other presumed winners in a Trump presidency might enjoy – we first need to look backward to the last pre-election expectations for corporate fundamentals.  A few points here:

• The November 11th edition of FactSet’s weekly Earnings Insight report is probably worth printing out and taping to your wall for the next 6 months. It is the last full survey of analysts’ revenue and earnings expectations for Q4 2016 and 2017 that in practical terms excludes the results of the U.S. election.  You can find it here: https://www.factset.com/websitefiles/PDFs/earningsinsight/earningsinsight_11.11.16
• The most important takeaway is that analysts were looking for 5.9% revenue growth for the companies of the S&P 500 in 2017, and 11.4% earnings growth. That is the benchmark to use in assessing all future changes in expectations.  Simply put, if the rally is to have a solid foundation eventually earnings estimates have to rise from these levels.  It may not happen in a week, or even a month, but earnings estimates need to start rising if for no other reason that interest rates have already started to track higher.  Valuation math is clear on this point: if rates rise, earnings need to increase or stocks fall.

• As for individual sectors, several of the groups with recent outsized gains are also the ones where analysts had been most aggressively cutting estimates over the month before the election. Expected 2017 earnings growth for the Industrials, for example, was 7.7% in October.  Last week, it was 4.3%.  A month ago analysts were looking for 10.3% earnings growth for 2017 in the Health Care sector; now that number is 8.8%.
• As for revenue expectations, Financials and Industrials have two of the lowest expected increases of any S&P 500 sector next year. As of the latest FactSet report, these are just 2.7% and 1.8%, respectively.  Only Telecomms have a lower expected sales growth for 2017, at 1.4%.
• Since the Dow Jones Industrial Average is actually the favorite child of the current rally, we also included in the attachment to this note our usual assessment of analysts’ revenue expectations for next Q4 and next year. The upshot is largely the same as the prior analysis.  Analysts are clearly still worried about current fundamentals, cutting Q4 revenue growth expectations to 1.6% over last year (down from 3.1% expectations last month).  Expectations for next year are for 4.5% revenue growth, down from 4.8% last month.

All this comes down to one word: leverage.  Not financial leverage, though…  Operating leverage. 

Prior to the election, investors didn’t believe there was much operating leverage available in corporate America.  Slow revenue growth, slow inflation, slow wage growth, slow earnings growth.  That was the recipe for next year. 

Now, expectations for better economic growth have markets scrambling to find companies with the operating leverage (read high fixed costs and high incremental margins) to show outsized earnings growth as a result.  It isn’t just that infrastructure spending will help Industrial companies; the magic here is that prior to the election no one expected much from this sector, and their high fixed costs meant that was a rational to be wary of any real upside.  Post-election, cyclical exposure and high contribution margins are a feature, not a bug.

Now, it is up to analysts and investors to parse out the future and determine if markets have run too far with this theme, or not far enough.  All we know is that U.S. stock prices expect more growth than they did a week ago.  And the more they rise, the more they expect.