Many professional investors will tell you that in the short run a whole variety of factors can impact stock prices but in the long run corporate earnings are the key factor that determines the value of a company’s stock. This is one of the reasons that earnings season (the period when companies report their quarterly results) is watched so closely and why analysts participate quarterly conference calls with company executives in an attempt to glean some information about the future path for company earnings.
Given the long-term focus on corporate earnings, the second quarter earnings report has created some concern on Wall Street. With the second quarter finally wrapped up for all 500 of the companies included in the S&P 500 index the results have been fairly disappointing. Officially, the second quarter earnings came in at $34.93 which is slightly down from the $35.02 reported in the first quarter and only 2.6% higher than the $34.04 reported in the second quarter of 2018. In general, earnings growth has been fairly flat following the sharp increase in 2018 due to the corporate tax cuts that took effect that year.
Wall Street analysts at many of the big investment banks are now rethinking their expectations for the remainder of the year. According to Yahoo! Finance the average earnings estimate for the third quarter earnings season, which will be underway soon, is a 3% decrease from the same quarter last year. The average expectation for all of 2019 is now a 6% decline in corporate earnings compared to 2018. However, it should be noted that many firms still expect earnings growth to recover in 2020. This is partially due to low interest rates allowing companies to refinance debts to reduce interest expenses. There has also been greater tax savings under the new corporate tax regime than was previously estimated given that many companies have been able to restructure their finances to take advantage of key provisions in the law.
Yet the Chief Executive Officers (CEOs) of major US companies may not be as optimistic about a rebound in earnings in the near future. In August a record 159 CEOs departed bringing the total for the year up to 1,009. This is a sharp acceleration from previous years. Some of these CEO departures reflect the weak earnings results as the CEO is often the first to be blamed, and sometimes forced out, when results are sub par. However, the majority of the CEOs that have left their post this year have done so voluntarily. This may be due to a desire to “go out on top” rather than be tasked with steering the company through a more challenging economic and earnings environment. Although demographics also likely play a role as many company heads are a part of the Baby Boomer Generation and are therefore reaching retirement age.
The weak earnings growth has also been reflected in stock prices. The S&P 500 finished the third quarter 2019 at 2,976.74, just 2.2% higher than the same quarter in 2018. This growth rate is similar to the 2.6% earnings growth rate over the same period. Therefore, it could be argued that the fairly flat returns on the stock market over the past year is a reflection of the slowdown in earnings growth. Naturally, this raises the concern that should earnings slump further as some predict it could pull the index value down in future quarters.
On the other hand, some argue that lower earnings expectations are a good thing. When the bar is lowered it can make it easier for companies to outperform their expectations and lead to a high percentage of positive earnings surprises. In fact, many companies try to manage their earnings guidance to keep expectations from getting too high so that the company will have an easier time meeting or exceeding those expectations when they report their results. In this case, even average earnings growth could lead to a fourth quarter market rally as it could quell investor fears over an impending earnings recession.