Strong earnings not enough to halt stock market’s slide

If you can follow only one bit of data, follow the earnings – assuming the company in question has earnings. I subscribe to the crusty notion that sooner or later earnings make or break an investment in equities. What the stock price does today, tomorrow or next week is only a distraction. – Peter Lynch

The month of October has lived up to its scary reputation as all three major stock averages tumbled last week with losses of 3% or more. Both the S&P 500 Index and the Nasdaq Composite Index officially entered correction territory, defined as a drop of 10% or more from their recent highs, although the S&P 500 managed to close above the 10% threshold on Friday. Even though third quarter corporate earnings have been strong, investors don’t seem to be paying attention as other factors have suddenly become far more important and have contributed to overwhelming negative sentiment. Of the S&P 500 companies that have reported earnings so far, nearly 80% of them have beaten analysts’ estimates and companies are on track to report earnings growth in excess of 22%. But this positive news doesn’t seem to matter as the stock prices of those companies that have topped expectations have fallen. To be sure, there are a number of worries that investors have that could explain the recent market volatility. These include trade tensions with China and the possibility of a protracted, full-blown trade war, rising U.S. interest rates and the chance of a policy misstep by the Federal Reserve, U.S. mid-term elections next week and geopolitical risks involving Brexit, Italy’s debt and a Saudi Arabian cover-up. Of these concerns, perhaps the biggest risk pertains to the Federal Reserve’s definition of a “neutral” federal funds rate. When Fed Chairman Jerome Powell commented a few weeks ago that the Fed is a long way from reaching a neutral level for the federal funds rate, the door was left open for continued rate hikes with no end in sight. These remarks spooked investors, who are now in the process of repricing financial assets to reflect this uncertainty. Despite these concerns, though, the economy remains strong with nothing that indicates that a recession is on the horizon.

Last Week

For the most part, economic data released last week also belied the stock market plunge. Third quarter gross domestic product (GDP) was 3.5%, better than expected, and growth for all of 2018 should be above 3%, something that hasn’t happened since 2005. Consumer spending was also strong and the preferred consumption expenditures (PCE) index, the Fed’s preferred inflation measure, increased less than expected. The University of Michigan consumer sentiment index in October remained at historically high levels and the weekly jobless claims rose slightly but were still consistent with a strong labor market with very few layoffs. On the negative side, U.S. durable goods orders in September were less than expected as businesses grew more cautious over trade tensions with China and new home sales in September were lower than anticipated.

The Federal Reserve Beige Book, which assesses the economic conditions across the country, reported modest to moderate growth in most Fed districts but increased anxiety among firms over the ongoing trade dispute with China and evidence of rising raw material costs.

For the week, the Dow Jones Industrial Average dropped 3.0% to close at 24,688 and the S&P 500 Index fell 3.9% to close at 2,658. The Nasdaq Composite Index declined 3.8% to close at 7,167.

This Week

The most important piece of economic data this week will be the October employment report, which is expected to show that about 190,000 new jobs were created and that the unemployment rate remained at 3.7%. September construction spending and factory orders are both expected to increase modestly while the October Chicago Purchasing Manager’s Index (PMI) is expected to remain comfortably above 50, the threshold for expansion.

The Bank of Japan (BOJ) meets this week and will likely keep its key interest rate unchanged at -0.1%.

This will be another busy week for earnings reports and the most prominent companies on the agenda include EBay, CBS, MasterCard, American International Group, Facebook, Apple, Pfizer, Amgen, Baxter International, General Electric, General Motors, Coca Cola, Starbucks, Chevron, Exxon Mobil, Duke Energy and Berkshire Hathaway.

Portfolio Strategy

The conventional wisdom was that once the third quarter earnings season began, the stock market would stabilize, find support and perform better. After posting 25% earnings growth in the second quarter, expectations were for continued strong profit growth in the third quarter and, up to this point, that has been the case. Not only have the majority of companies topped earnings estimates, but average earnings growth has been over 20%. The earnings results of four notable companies last week may illustrate why stocks continue to be weak. Not only did 3M miss both earnings and revenue estimates, but the company reduced its earnings outlook for the balance of the year. A strong dollar and the potential impact of tariffs have created headwinds for multi-national companies such as 3M. Although Caterpillar easily beat profit estimates on both the top and bottom line, the company’s guidance was below the consensus due to the effects of tariffs. Two of the so-called FAANG stocks, Amazon and Alphabet (Google), also handily beat earnings expectations last week. The stock of Amazon plunged because the company forecast weaker than expected sales and earnings for the fourth quarter while Alphabet’s stock sank because its sales were soft. Both of these stocks had benefited from momentum and were trading at price earnings multiples that were much higher than the overall market. Because they were priced for perfection, any disappointment would likely send their stocks lower. If there is a silver lining in the recent market sell-off, it is that stocks are now trading at just over 15 times earnings estimates for 2018, which once again makes them attractive.