Over the past few quarters, the corporate earnings seasons proved to be a powerful catalyst for Wall Street, with U.S. stock-market investors seeing strong company results as justification for equity valuations. In the upcoming quarter, however, the outlook is a lot cloudier.
While profits are expected to be strong in the upcoming fourth-quarter reporting season, with the S&P 500 SPX, +0.17% posting earnings growth in excess of 10%, the results may provide less clarity into the state of corporate America than is typical, given the variable of the recently passed tax-overhaul bill in Washington.
The bill, among other changes, cut the corporate tax rate, and while optimism over that move has contributed to major indexes hitting multiple records of late, it could also make evaluating corporate reports more difficult than normal this quarter. Goldman Sachs wrote that the legislation “will muddy underlying company fundamentals.”
The investment bank explained: “Firms will be forced to remeasure the value of their deferred tax assets and liabilities at the new 21% statutory federal corporate tax rate. Companies will record a tax expense (benefit) if deferred tax assets are greater (less) than deferred tax liabilities.”
In Goldman’s view, both deferred taxes and overseas cash could prove to be two key sources of uncertainty in the quarter, and that for the companies that only report GAAP results (which stands for Generally Accepted Accounting Principles; non-GAAP results often correct for one-time charges), “the headline impact could be substantial.”
Goldman added, “Short-term implications of the tax bill will result in companies taking a number of one-time charges against earnings. We expect investors to look through a noisy [fourth quarter] and focus on the effects of tax reform on 2018 [earnings per share].” In a note to clients, it wrote that “Markets have moved faster than analysts, but recent revisions to 2018 EPS suggest analysts are starting to incorporate tax reform into their estimates.”
The fourth-quarter season is seen as unofficially starting later this week, with results from such large-capitalization financial stocks as J.P. Morgan Chase & Co. JPM, +0.15% and Wells Fargo & Co. WFC, -1.13% . Per Goldman’s data, 63% of the S&P 500’s components will report over the coming three weeks, and the growth is expected to be broad-based. According to FactSet, every one of the 11 primary S&P 500 sectors had positive growth in 2017. However, much of the growth was concentrated within just three sectors: energy, materials and technology.
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A lower tax rate is seen as providing an immediate boost to profitability, without any change in underlying demand. According to Bespoke Investment Group, the percentage of companies in the S&P 1500 SPSUPX, +0.19% with positive earnings-estimate revisions is at its highest level in more than a decade, as seen in the following chart.
This isn’t necessarily good news. Liz Ann Sonders, the chief investment strategist at Charles Schwab, tweeted that this was “more of a contrarian indicator.”
The impact of the tax bill could be long lasting and have an impact on 2018 results, which are already expected to grow 11.4% over 2017. That would represent the highest rate of growth since 2011, according to CFRA.
Lindsey Bell, an investment strategist at CFRA, wrote that she expects 2018 earnings estimates to be raised higher still, due to adjustments made as a result of the tax plan. “This is contrary to normal behavior for earnings growth rates, which typically move lower as the year develops. Specifically, growth can end a year 550 basis points lower than the January 1 estimate.”
Since October, fourth-quarter earnings estimates have only dropped by 70 basis points (0.7%), something Bell wrote was “notably rare” in how small the reduction had been.
While higher profits are obviously a tailwind for equity prices, Bell said she didn’t expect these factors to result in further gains for the U.S. stock market over the near term.
While the small reduction in estimates “suggests this quarter’s results could end much better than the current year-over-year consensus earnings per share growth estimate of 10.6%, we view the outsized gain in the S&P 500 since mid-November as reason for a period of consolidation or even a small pull-back as the reporting period unfolds, similar to what was experienced throughout 2017,” she wrote.