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Brian Andrew, CFA

Earnings Season Arrives

Since Dec. 31, we have been anticipating the beginning of the first quarter earnings report season. Expectations are high for corporate earnings growth in 2018, and the first quarter reports will provide a picture into how companies are growing revenue and profit as well as benefitting from tax reform. With an expected growth rate of more than 15% for S&P 500 Index companies' earnings, the bar is set very high.

Earnings reports also provide evidence of whether or not revenue growth is taking place. If broad‐based, that suggests a pickup in economic growth and supports the notion that 2018 can be a good year for the economy and stocks. However, when expectations are very high, there is little room for error.

First Reports

The reporting season began last week with some of the major banks discussing their first quarter financial results. JP Morgan, one of the world's largest financial services institutions, reported revenue of $28.5 billion and earnings of $2.37 per share. Importantly, CEO Jamie Dimon described global economic growth as positive and noted that they “. . . remain optimistic about the positive impact of tax reform in the U.S.” He also described the lending climate as positive and said their expectation is that core loan growth would be in the 6‐7% range. He forecast their effective corporate tax rate to be near 20%. All in all, this was a stellar report for the bank, and investors should have been pleased. The stock sank 2.7% on the day the report was released.

In fact, the same day, we received positive reports from other large financial institutions, and their stocks sank as well. How can this be? It is a reminder of that high bar of earnings expectations.

Stocks rose more than 20% in 2017. As tax reform became a reality, expectations for better earnings continued to rise, and U.S. stocks rallied another 8% in January. Despite the volatility in February and March, JP Morgan's stock was still up 6% on the year the day before their earnings report. Upon hearing the good news, investors may have thought, “This report sounds like what we expected, not more than we expected.”

Therein lies a cautionary note about expectations for stock price appreciation this year. When companies report record revenues, improved profits and great earnings, and then suggest that they expect those kind of results to continue, investors may bid up stock prices. However, when that kind of good news has already been anticipated, it becomes harder to impress those equity investors with results. Moreover, investors may fret that producing year‐over‐year growth against this strong backdrop will become even harder.

Still, Jamie Dimon's statement about good global economic growth, a favorable tax rate and growth in his core businesses suggests he is optimistic about this year's earnings outcome.

Volatility Advantage

The CEO's optimism coupled with JP Morgan's first quarter results suggests that this will be a good year for the company. So far, 23 companies in the S&P 500 Index have reported their first quarter earnings – 65% of them have beat those optimistic estimates and 9% have met them. The average positive surprise (meaning the percentage above expectations) was 11.4%. This is significant on top of high expectations. Yet the market is little changed. Again, expectations are very high, and it is hard to impress investors with those expectations.

However, we know that volatility has also increased dramatically since the end of January and believe this can be used to our advantage. With earnings expectations high, and if reporting season continues at this pace, having the opportunity to buy stocks when they are cheaper makes sense to us.

At times during the last two months, stocks have sold off more than 10% from their highs. More importantly, corrections have left them trading near 16 times the next 12 months' earnings versus the 19 times they traded at the peak in January. The ability to buy a future earnings stream that is expected to grow at 15% (the S&P 500 Index’s earnings growth rate in 2018) at a lower price could be beneficial.

While 16 times earnings is not inexpensive, buying stocks at that price, given the strong backdrop for economic and earnings growth, would be advantageous. The market’s volatility could provide this opportunity more often.

It's important to pay attention to the volatility that arises from geo‐political concerns. Whether it is the threat of an escalation with Syria or talks with North Korea, these events aren't likely to impact corporate fundamentals in the near‐term. They may, however, have a negative impact on stock prices, thus providing the opportunity for investors.

Expectations regarding earnings are high. It might just be that companies continue to surprise investors and produce results that beat expectations and make way for positive returns in 2018. So far the earnings season suggests that what we hoped for is what we'll get.

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Views and comments expressed in this blog are those of the author and do not necessarily represent the positions of Cleary Gull or fellow Cleary Gull associates.