Overoptimism and the earnings recession
A lot of articles were written last week about the fact that earnings growth expectations in the US for the first quarter 2019 have become negative. At the beginning of the current earnings season, earnings growth in the first quarter 2019 was expected to be around 8.5%, but as more and more companies warned of a difficult market environment this year, downward revisions pushed expectations lower and eventually into negative territory.
Our chart shows that negative growth expectations for the first quarter not only prevail in the US but also for the companies in the FTSE 100. The earnings profile for UK companies is the classic Brexit picture that we can also see in economic forecasts: a bad first quarter but then an acceleration as pent-up demand gets released, once the UK has managed to negotiate a deal and smoothly exits the EU. Ask any economist or investment strategist and a no deal Brexit is simply not conceivable for any of them. And while we think as well that some kind of deal will be struck before the UK leaves the EU, I have to wonder what happens if we are wrong?
In my experience, the time to become careful is when everybody agrees. Over the last couple of years, there have been several instances when 100% of surveyed economists expected bond yields to rise. And that is usually when they dropped even more. The maths is simple - if bond yields are supposed to rise, investors want to sell their bonds, but if everybody agrees that bond yields will rise, who is there to buy the bonds? Unless you have a price insensitive buyer like a central bank the market will just dry up and yields will stop rising.
Similarly, if everybody agrees that a hard Brexit will be avoided, what happens when everybody tries to run for the exit on 29 March should there be no deal?
While it is too early to prepare for such a catastrophic scenario in the UK, it shows once more that human beings are chronically over-optimistic and willing to accept negative outcomes only once they become inevitable. Neurological studies have shown some time ago that optimism is hard-wired in our brains and it is only the clinically depressed that do not display overly optimistic assessments of their own abilities or future events.
In financial markets this optimism bias is visible everywhere. Economists hardly ever predict a recession and investment analysts systematically overestimate future earnings growth for example. Earnings growth expectations for the MSCI World have been on average 12.5 percentage points too high over the last twenty years and in the US the average has been 8.5 percentage points. So, if analysts now expect negative earnings growth in the first quarter of 2019 and a mere 11% earnings growth over the next twelve months for the S&P 500 and 10% for the MSCI World, does that mean that we are in for a nasty surprise?
Given the average level of over-optimism, I certainly would not expect strong earnings growth in 2019. Economic growth in Europe and China is low and slowing down in the US, so it would be foolish to expect much from corporate earnings. But the problem is that the level of over-optimism is not stable over time. History shows us that analysts tend to be too optimistic at the height of an economic expansion and too pessimistic at the bottom of a recession. Effectively, analysts are trend followers in their earnings forecasts and essentially project the most recent past out into the future. And this recency bias should make us confident that at least in the US, earnings expectations might currently be too low.
Expected earnings growth of -1.5% in Q1 2019 and +1.6% in Q2 2019 are low hurdles to jump and given the continued decent growth in the US, I would expect many positive surprises in the upcoming earnings seasons, which should lead to higher share prices. In the Eurozone, on the other hand, analysts still expect +2.1% earnings growth in Q1 2019 accelerating to above 12% in Q3 and Q4 2019. Where this earnings explosion should come from is a mystery to me, so I remain cautious about Eurozone equities for now.
Expected quarterly earnings growth
Source: Bloomberg, Fidante Capital.