The S&P 500: The Big Picture
Earnings season is upon us once again, putting the stock market at another inflection point. With the S&P 500 (SPY) and other major indexes trading at all-time highs companies are likely going to have to report relatively strong Q2 earnings to keep stocks from slipping lower. More importantly, corporations will likely need to provide relatively robust 2H guidance to keep the current stock rally alive going into the fall and year-end.
S&P 500 1-Year
Several crucial factors capable of propelling the S&P 500 and stocks in general higher appear to be aligning. Most notably, the Fed put is clearly back on the table in a big way. Also, there appears to be some thawing in the China/U.S. trade relations. Corporations are likely to continue with their near-record buyback programs as well.
However, there are also some signs that suggest the economy is slowing. This is why it is imperative that U.S. corporations provide relatively strong earnings reports for Q2 and, more importantly, provide adequate guidance for the second half of the year. This crucial part of the puzzle must fall into place for the S&P 500/SPY and stocks in general to continue their march higher from here.
Let’s Look at Earnings
Earnings season is just getting started, and out of the major corporations that have reported so far, PepsiCo (PEP) beat EPS estimates by 3.4%, Delta Air Lines (DAL) beat by 2.62%, Infosys (INFY) met estimates, but that is about it so far.
However, the real earnings season is about to begin with big banks like Citigroup (C), Goldman Sachs (GS), JPMorgan Chase (JPM), Wells Fargo (WFC), American Express (AXP) and other juggernauts in the financial industry getting set to deliver results within days.
Bank earnings are important, as they give a glimpse into the health of the U.S. consumer, and the overall credit/lending markets. Also, it is going to be interesting to see what kind of impact future Fed policy will have on 2H earning and beyond.
Like last quarter, I predict banks will provide better-than-expected results. I also believe that the Fed’s easing path will have a very limited impact on bank earnings in 2H. Therefore, I am relatively bullish on banks for the rest of this year, especially with their uber-low P/E ratios, likely buybacks, and potential for dividend increases. However, in 2020, if the Fed continues to ease, bank earnings will likely be impacted negatively due to lower interest rates.
Naturally, banks are not the only systemically important stocks I will be looking at closely this earnings season. We also have Canadian Pacific Railways (CP), Union Pacific (UNP), and CSX Corporation (CSX) reporting within days. Railway companies are especially important, as they are part of the bloodline interconnecting the entire nation, illustrating the strength for goods demand and other elements in the U.S. market. Forward guidance will be particularly interesting to observe in these names.
Other big earnings on deck this week include companies like Johnson & Johnson (JNJ), United Airlines (UAL), Abbott (ABT), eBay (EBAY), IBM Corp. (IBM), Kinder Morgan (KMI), Netflix (NFLX), Danaher (DHR), Honeywell (HON), Microsoft (MSFT), Blackstone (BX), UnitedHealth (UNH), BlackRock (BLK), Schlumberger (SLB), and others.
The magnitude of the companies about to report this week should provide us with a relatively good idea of what the rest of Q2 earnings may look like and, more importantly, should provide us with a glimpse into 2H guidance and further expectations.
The good news earnings-wise is that consensus estimates appear quite attainable, as most are just marginally higher on a YoY basis. The bad news is if major companies begin to miss estimates, and worse, offer poor 2H guidance, the Fed put may not be enough to save the economy and the stock market.
Just for reference: Some consensus Q2 EPS estimates appear as follows on a YoY basis.
- Citi is looking for an increase of 10%.
- Canadian Pacific is looking for an increase of 30%.
- CSX is looking for an increase of 10%.
- JPM is looking for an increase of 9%.
- Wells Fargo is looking for an increase of 7.4%.
- Kinder Morgan is looking for an increase of 9.5%.
- Microsoft is looking for an increase of 7%.
- American Express is looking for an increase of 11%.
- UNP is looking for an increase of 7%.
As we can see, consensus estimates do not appear to be overly bullish, as most companies are expected to beat last year’s EPS by single or low double digits. Certain companies like Goldman Sachs, Morgan Stanley (MS), Netflix, and a few others are even expected to show YoY EPS declines. However, this is likely due to one-time charges and other irregular phenomena, not suggestive of a significant slowdown in the overall economy.
Tech Earnings Outlook
I am also looking very closely at big tech earnings and their forward guidance, as this should provide some crucial insight into just how destructive the recent “trade war” has been for major technology firms and their future earnings potential.
I believe the impact may be more limited than what has been advertised in the media, and tech earnings along with forward guidance should be largely in line, or possibly better than expected even. The reason why tech may surprise higher is because all the panic surrounding China has forced many analysts to lower estimates in recent quarters.
Also, it is crucial to point out that SPY, much like the S&P 500 Composite, is extremely tech-heavy, with about 26% of the index’s total weight being in Technology. Therefore, if Technology stocks do well, this should help the overall market move higher. Additionally, financials and healthcare account for about another 30% of the index’s weight. This essentially means that 56% or so of the S&P 500 is comprised of companies in these 3 sectors.
The thesis is that banks are cheap, should report relatively well, and bank stocks should move higher. Impact on technology names should be more limited than expected from China trade tensions. These names are also relatively inexpensive right now, and should proceed to new all-time highs in 2H. Healthcare is a far less cyclical sector, is a good defensive place to rotate capital to, and there are a lot of inexpensive, high-quality names in this space as well. Thus, these major sectors, along with others, should pull SPY, the S&P 500, and stocks in general higher in the second half of this year.
From a P/E Ratio Perspective
Aside from some of the overbought “defensive sectors” like utilities, consumer staples, and real estate, stocks do not appear particularly expensive right now, especially if most companies can meet or beat consensus EPS estimates for 2019.
For instance, the DJIA is trading at only 18.8 times earnings. This is compared to nearly 25 times earnings one year ago. Therefore, the DJIA is essentially 25% cheaper today than it was 1 year ago. On a forward P/E basis, the DJIA is trading at just 16.87 right now.
Similarly, the Nasdaq 100 is trading at 25 times earnings, cheaper than last year’s 26.5, and has a forward P/E ratio of just 22. Also, if tech can beat EPS estimates, the Nasdaq 100 may be trading at around 20 (forward P/E) or lower. Likewise, the SPX is trading at around 23, cheaper than last year’s 24.5, and has a forward P/E of just 18.
The takeaway here is if U.S. companies can deliver earnings as expected or better, we can probably see P/E ratio expand. Furthermore, if the SPX achieves its 18 times forward EPS estimate and P/E ratios remain constant at 23 a year from, the S&P 500 could rise by about 28% from current levels (if it can achieve analysts’ estimates and its P/E ratios remain at a similar level as today). A 28% gain from current levels would bring the SPX to around the 3,900 level.
So, could we see the S&P 500 at 3,900 one year from now? Yes, it is possible, but we need the Fed to stay ultra-accommodative, we need to normalize China/U.S. trade relations (significantly lower tariffs on Chinese imports), corporations need to continue their huge buyback programs, and perhaps most importantly, corporations need to deliver in-line or better-than-expected earnings results for S&P 3,900 to materialize. Naturally, the economy needs to avoid a recession in this time, but given the potential materialization of the factors I mentioned, this should be enough to enable the U.S. to avert a recession for now.
Here’s Where the Economic Picture Starts to Worry Me
I would like to draw your attention to a few troubling elements. Perhaps the most disturbing factor right now is the apparent slowdown in the freight/trucking industry. The trucking industry is experiencing excess capacity and lower volumes. Now, this is likely in part due to higher tariffs on Chinese goods, and it may be a transient phenomenon that could pass as trade relations normalize in the future. Nevertheless, it is concerning – and it’s not just trucking. A similar situation can be observed in the shipping and railroad industry as well.
Also, recent manufacturing PMI figures came in at 50.6. While this was better than the expected 50.1 estimate, it still points to a very sluggish manufacturing base in the U.S. that is barely expanding. Again, this could also be associated with recent trade tensions, and numbers may improve if trade relations with China improve. However, the slow manufacturing figures, coupled with the slowdown in the freight, railroad, and trucking industries, could be pointing to an upcoming recession in the U.S.
U.S. Manufacturing PMI
Image Source; I have to admit, this chart concerns me.
The Big Question
The big questing is whether the Fed can stimulate the slowing economy enough to prevent it from falling into a recession. Another big question is whether China/U.S. trade relations can improve enough to significantly lower tariffs on Chinese goods, improve relations, and stimulate the global economy, but most importantly, fuel the economy in the U.S.
The Good News
The good news is that the Fed is ready to act, as there is a 100% probability of a rate cut this month. Moreover, there is about a 25% that the cut will be 50 basis points and not just 25. This alleviates some negative headwinds, reinforces confidence and sentiment, and could potentially delay the impending recession. Thus, the S&P 500/SPY and stocks in general could continue their rally from here.
The Bad News
The bad news is that no matter what the Fed does, it will not be able to save the economy and the stock market from the impending recession forever. Moreover, I don’t believe the Fed will be able to do it for long. The economy and the stock market could continue to expand for several more quarters, and with enough effort from the Fed, fresh rounds of QE, etc., it is possible that the economy may overcome this “transitory” slowdown and may continue to expand for years. However, I don’t believe this will be the likely scenario.
In my view, we could have a relatively strong 2H, the SPX could climb to around the 3,500 level, but in 2020, a recession coupled with a bear market appears possible, if not likely.
The SPX has clearly broken out above prior all-time highs and is in the process of breaking out above the psychologically important level of 3,000. I think we could see a nice melt-up to the 3,100 level before the next minor pullback or consolidation period occurs. Then, we are likely to proceed higher after that.
The 3-year chart shows us a relatively nice trend higher that is likely to continue from here.
The Bottom Line: Stay Optimistic but Remain Cautious
Keep a close eye on Q2 earnings and forward guidance, as any potential weakness in this area could signal that a recession is approaching sooner than later. Also, pay close attention to the shipping, trucking, and railroad industries, because if the slowdown in these industries continues, it further reinforces the idea that a recession is approaching.
At the same time, I believe earnings will be mostly robust for Q2, and 2H guidance could be in-line or better than expected even. This is especially true if trade tensions ease and tariffs are lowered on Chinese imports.
Also, a key factor is the Fed, and from my experience in markets, you don’t want to fight the Fed, as it has ample tools to stimulate the economy and delay the impending recession. This is especially true if the Fed proves to be proactive, lowers rates in a timely manner, and implements QE in a preventive fashion, not as a reactive measure.
Ultimately, I think the S&P 500, SPY, and stocks in general could have a strong 2H, and if the positive elements I mentioned materialize in a substantive manner, we could be looking at an S&P 500 between 3,500 and 3,900 a year from now.
In a more bearish scenario, where earnings and guidance are slightly weaker than expected, trade relations don’t achieve satisfactory levels, and the Fed somehow finds itself behind the curve, the S&P 500 could top out at around 3,500 by the end of this year to early 2020, and we may be confronted with a recession coupled with a bear market in equities in early 2020.
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Disclosure: I am/we are long NUMEROUS STOCKS IN THE S&P 500. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
Additional disclosure: This article expresses solely my opinions, is produced for informational purposes only and is not a recommendation to buy or sell any securities. Investing comes with risk to loss of principal. Please consider consulting a professional before putting any capital at risk.