As we kick off earnings reporting season on the heels of the end of Q2, we have to remember that earnings are important, but only as they relate to expectations. The stock market is a discounting mechanism, and it sets those expectations on a daily basis (which is why the market moves all the time). Psychology is the other part of market pricing mechanisms. We’ve discussed psychology many times in the past and for shorter time periods this can be more impactful that future earnings growth expectations. So, let’s look at earning expectations from the leader in that space, FactSet. They compile all the earnings changes from analysts as well as company commentaries and guidance (most companies issue “low ball” guidance).
Since March 31st, earning expectations have been coming down and are currently expected to be down 3% for the quarter. If those expectations come true (a big “if”), it will be the first time since 2016 that we have had back-to-back quarters of negative earnings (or what is known as an earnings recession).
The forward valuation in the market is higher than both the 5- and 10-year average. With low and potentially lower interest rates going forward, you can justify an above average price-to-earnings (P/E) ratio. Expectations are for the 3rd quarter to have negative growth, but then returning to moderate profit growth in the 4th quarter.
With psychology not extreme, as we have pointed out many times, and expectations relatively muted at this time, that is giving us more confidence in our thesis on the market. That being that the “pain trade” is still higher; most fund managers and individuals are underinvested in the market and are seeking the “safety” of low yielding bonds.
We would still argue that we are late in the cycle, but as we have said many times before, you can get really nice rallies before the forces of economics ultimately prevail (for a convenient analogy, look no farther than how the Mariners started the season and where they are today). Those forces would be expensive multiples, high debt loads, and extreme optimism. When that happens, the cycle will be over, and the next cycle will start.
We continue to be cautiously optimistic for the public markets and we will continue to stay vigilant and if we need to, we will take protective measures. Our optimism for summer in the Northwest is less certain, but maybe that means less forest fires as a result.