SP 500 Earnings: How Much Earnings Growth is Tax-Reform Related and a Year of PE Contraction

Updating the weekly numbers: (Thomson Reuters)

  • Fwd 4-qtr est: $169.21 vs last week’s $169.13
  • P.E ratio: 17x
  • PEG ratio: 0.77x
  • SP 500 earnings yield: 5.83% vs last week’s 5.88%
  • Year-over-year growth of fwd est: +22.39% vs last week’s +22.20%

With one month remaining in the 3rd quarter, its unlikely that 3rd quarter, 2018 estimates will change much from today.

The 3rd quarter SP 500 estimated earnings growth is expected to come in at +22.4%, versus the +23.4% estimated on July 1 ’18. That is a very minor downside revision during the point of the quarter where – historically anyway – negative revisions can be quite substantial.

Something not done on this blog is to look at how the 2nd quarter earnings growth estimates changed over the last 60 days as SP 500 components reported 2nd quarter earnings:

  • Cons Disc: +23.1% today vs 16% estimate as of July 1;
  • Cons Spls: +13.8% today 10% estimate as of July 1;
  • Energy: +123.1% today vs +140.9% estimate as of July 1;
  • Financials: +27.2% today vs. 22% estimate as of July 1;
  • Health Care: +18.1% today vs 11.1% estimate as of July 1;
  • Industrials: +20.3% today vs 14.9% estimate as of July 1;
  • Basic Materials: +40% today vs 33.3% estimate as of July 1;
  • Real Estate: +3.3% today vs 2.3% estimate as of July 1;
  • Technology: +26.9% today vs 25.5% estimate as of July 1;
  • Telco: +16.4% today vs 7.4% estimate as of July 1; (The telco sector will be absorbed into the Communication sector in Sept ’18)
  • Utilities: +8.7% today vs +1.3% estimate as of July 1;

With 496 of the SP 500 having reported 2nd quarter, 2018 earnings by now, readers can see the increase in each sector’s expected earnings growth once the reporting season began.

Here is the progression in “expected” 2nd quarter, 2018 SP 500 earnings growth through the year:

  • 8/31/18: +24.9%
  • 7/1/18: +20.7%
  • 4/1/18: +19.8%
  • 1/1/8: +11.4%
  • 10/1/17: +9.9%

So what’s the point of all this ?

Jeff Miller, the famed blogger at www.dashofinsight.com and an industry friend here in the Chicago area and I had lunch on Friday, August 31, and we talked about the impact of tax reform on earnings.

Using rough math – and this is hardly scientific – by using the above Thomson data, expectations for Q2 ’18 SP 500 earnings growth “pre tax reform” was +9.9%, and today the “actual” is closer to 25%. My own estimate is that the “core” US economy can generate 5% – 10% earnings growth over the long term (the post WWII average for valuation models typically use 7% annual earnings growth) so we could probably conclude that at least 50% of the 23% – 25% SP 500 expected earnings growth for full-year 2018 will be “corporate tax rate” driven.

To be clear to readers this isn’t an “academically-rigorous” exercise: how do you quantify the stronger consumer confidence impact on SP 500 earnings ?

There are so many different variables to consider.

One of the best guides to tax reform’s impact in 2018 is that current Thomson Reuters IBES expects the SP 500 to return to 9% – 10% earnings growth in 2019.

It’s a little early yet to hang our hat on that estimate as being reasonably accurate but my own guess is we see “low-teens” SP 500 earnings growth in 2019, all of it “organic” as opposed to tax-rate driven.

I’d be happy with 12% – 15% SP 500 earnings growth in 2019, but readers should expect the SP 500 to generate lower earnings growth in 2019.

To further complicate issues, 2018 has been a year of PE contraction for the SP 500: SP 500 earnings growth will be 20% – 25% in calendar, 2018, while SP 500 has returned just 8% year-to-date. In most normal year of market action, the SP 500 sees “PE expansion” where the SP 500 return is greater than the SP 500 earnings growth for that calendar year.

Here is how rare “PE contraction years” are for the SP 500: 

  • 2018: SP 500 earnings growth of 20% – 25%, SP 500 total return 10% ?
  • 2011: SP 500 earnings growth of 15%, SP 500 total return 2.11%
  • 2002: SP 500 earnings growth of 6%, SP 500 total return was -22%
  • 2000: SP 500 earnings growth of 8%, SP 500 total return -9.1%
  • 1994: SP 500 earnings growth of 20%, SP 500 total return 1.32%

Analysis / conclusion: This should have been two different articles, but I wanted to point out tax reform’s impact on the SP 500, which would still be growing slightly above average (maybe more) even without tax reform, and that 2018 is a year of PE contraction for the SP 500, which is pretty rare for the benchmark. (The above detail covers the 33 year period from 1985 to 2018.)

In the 1982 – 1999 secular bull market, there was only one year of “PE contraction” and that was 1994. The point could be made that the years 2000 – 2009 was an entire decade of PE contraction.

My own conclusion is that 2018’s “PE contraction” is being driven by the unusual and 1-time corporate tax rate reduction, and that – like 2000 through 2002 – this isn’t the start of a period of PE contraction in the US stock market.

“Normal” return years typically see years of PE expansion. 2018 is a reset year, but I do think the SP 500 remains in a secular bull market.

Thanks for reading a longer-than-intended article this weekend, Back with more over the long Labor Day weekend.


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