The sky is falling! Or maybe not, depending on where your money is parked.
Reports from FactSet—a standard source of data for financial professionals—have been warning about an earnings recession in the S&P 500. That's the investor's equivalent of a recession, where earnings, not GDP, drop two quarters in a row. In its latest report, FactSet estimated an earnings drop of 1.9% in the second quarter of 2019. That follows a 0.5% decline in the first quarter. If that Q2 estimate is correct, there would be an official earnings recession
"The basis for valuations of stocks is earnings per share [or EPS]," said Patrick Chovanec, chief strategist at Silvercrest Asset Management. As EPS is the basis of stock value, when it falls, share prices might follow. When that happens across an entire index, as FactSet suggests is the case, the news isn't good for markets.
But as during an ordinary recession, not all companies are equally at risk. Some companies that perform better during a downturn are considered "counter-cyclical." For instance bankruptcy advisors or outplacement agencies may fare better as the economy worsens as they make their money from corporations restructuring or going under. High discount stores may do better because there is increased excess inventory to gain at a bargain and more people that need to save money. There are also non-cyclical businesses—pharmaceuticals, auto insurance, utilities, or household goods. People can't so easily do without them.
Similarly, not all economic sectors are in danger of an earnings recession.
The FactSet analysis is across the entire S&P 500. It includes actual earnings (if already announced) or an average of majority analyst estimates (if not reported), according to a clarification of method the company sent to Fortune. But that has two weaknesses. The first is that it's an average. You can't see which companies or sectors might be doing better or worse.
The second is that the final earnings happen after taxes. Companies frequently use many tax strategies to make their revenues look lower and their costs higher on paper to minimize the amount of tax they pay. That can make actual profits—earnings—look smaller. The businesses may actually be more robust than the earnings seem.
Using earnings from operations
"Right now I'm looking at the S&P 500 operating earnings," said Brad McMillan, chief investment officer for Commonwealth Financial Network. Those are the profits a company sees after costs directly associated with running the business but before interest expenses and taxes. McMillan says that the operating earnings are actually up from quarter to quarter and year over year.
While operating earnings get closer to the ongoing health of a company—barring the negative impact of high debt interest or wide variations in taxation—the average across the entire S&P 500 still misses some important details.
Chovanec did a sector analysis of data from Standard & Poor's, the home of the S&P 500, and found that while "overall earnings per share was up a bit … 8 out of 11 sectors were down year on year."
"The overall market number for EPS masks a very uneven picture underneath that a number of sectors are either in an earnings recession or something close to it," he said. "That raises questions of the strength of the economy, whether we should be concerned about a recession if this doesn't turn around in some way. That's why the Fed is looking at potentially cutting rates and why people are looking for a rate cut."
"That raises questions of the strength of the economy, whether we should be concerned about a recession if this doesn't turn around in some way. That's why the Fed is looking at potentially cutting rates and why people are looking for a rate cut."
In other words, three sectors—financials, healthcare, and utilities—were keeping the difference in operating earnings of the entire S&P 500 index between the last quarter of 2018 and first quarter of 2019 at a positive 8.4%. Year over year, the growth was up 4.0%. "Everything else is down, some by large amounts, some by smaller amounts," Chovanec said.
So far in the second quarter, year-over-year results are "not looking very impressive," Chovanec said. Expected quarter-to-quarter operating earnings growth was 3.6% while the year-over-year growth is expected to be 1.9%. "Healthcare is positive by 32% [year over year] and IT information technology is positive by [about] 2%. Behind the mildly positive index level numbers, there are only a few sectors propping that up and the rest of it is in what arguably in what could be described as an earnings recession."
The sectors on the down side include consumer discretionary, consumer staples, energy, industrials, materials, communication services, utilities, and real estate.
That might suggest some portfolio balancing. "We're trading at 19 plus times earnings," said Ron Weiner, partner and managing director at RDM Financial Group at HighTower Advisors. That compares to an historical figure in the mid-teens for the S&P 500.
To get broad share price growth, companies would need generally higher margins in their businesses, which doesn't seem likely, he said. "You have to be more of a stock picker or sector picker to make money. We're keeping with healthcare, technology, and probably financial [services]."
That might mean choosing individual stocks or specialized ETFs that focus carefully on given sectors. But check their performance carefully, as even the best pickers can find themselves with a basket of junk instead of cleverly discovered gems.
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