November 19, 2018
President Trump’s plan to stimulate the economy, known as The Tax Cut and Jobs Act, was signed into law at the end of 2017. It ushered in a massive and permanent tax cut for corporations, along with a temporary reduction in rates for individuals. Consequently, earnings growth has soared this year when compared to the same period in the prior year. Companies in the S&P 500 grew their earnings by 25.6% in the third quarter of 2018 compared to the same period in 2017, according to FACTSET. And earnings growth is set to rise by 19% in the fourth quarter of 2018 y/y.
But things aren’t looking nearly as good for next year’s comparisons. EPS growth for the S&P 500 in the first quarter of 2019 compared to 2018 is estimated–by the, it’s always sunny outside crowd on Wall Street–to be 9.5%. But this guestimate might very well turn out to be extremely optimistic.
During the second quarter of this year, the economy grew at a 4.2% Q/Q SAAR. The third quarter growth in the U.S. saw the economy decelerate to 3.5%. And, according to Bloomberg, the estimate for fourth-quarter growth of this year will be 2.7%. Keeping with this trend in slowing growth, Q1 2019 is projected to post growth of just 2.4%–there is no doubt that the U.S. economy is in the process of decelerating.
Given the strong headwinds hitting the global economy right now, and the fact that no economy exists on an island, it seems very likely that U.S. corporate profit growth could struggle just to remain in positive territory during 2019. Those headwinds include: The Fed continuing along its interest rate hiking path, while it also removes $600 billion from the financial system. Global central banks that have turned hawkish, causing the amount of QE to crash from $180 billion per month in recent years, to zero. Corporation are seeing profit margins shrinking from rising wages, much higher interest rates expenses and a stronger dollar. The end of trade war front-running, which caused a huge inventory build and a temporary boost to growth. Emerging Markets turmoil is worsening. The U.S. is posting trillion dollar deficits and that amount of red ink is only getting bigger, and finally, the debt-disabled global economy is rolling over hard, causing stock market collapses and putting downward pressure on consumers worldwide.
In addition to all those factors, corporate profits face extremely difficult comparisons due to the lapping of the repatriation of foreign earnings, along with the tax stimulus package.
This year started off with an extreme level of investor optimism. Equity markets were supported by the outlook for a continuation of synchronized global growth. Nevertheless, the global economy is now weakening, as global monetary policies are tightening into record levels of debt.
This is causing turmoil in currency, bond and equity markets across the globe. In this environment, it seems highly likely that S&P 500 earnings will struggle to grow at all. Indeed, the level of earnings for the S&P could find it difficult to remain at the $162.48 level that is projected by FactSet for calendar 2018. Therefore, investors need to reprice the rosy forecast of $177.90 for TTM 2019 that is currently hoped for by Wall Street.
Not only is it the case that EPS growth will be far less than the 25% seen earlier this year; it is very likely that there will be an earnings recession next year. If this is indeed the case, the market will be forced to place a much lower multiple on that plunging growth rate of earnings.
The current forward multiple on the S&P 500 EPS is 15.6. But this considers a robust growth rate that is near double digits. If the EPS number next year comes in closer to the same low $160’s EPS level seen in the trailing twelve months of this year, the multiple on those earnings should be closer to 14x…at best. Hence, if this assessment is anywhere near correct, the S&P 500 should trade around 2,240 at the end of next year. That would equate to a drop of nearly 20% from the current level.
It is of paramount importance to note that those EPS figures are grossly overstated due to a decade’s worth of debt-fueled stock buybacks that have been prompted by near zero percent borrowing costs. Therefore, the fair value of the S&P 500 would only be achieved from a plunge much greater than 20%.
The last earnings recession occurred during calendar year 2015; where EPS for the S&P 500 dropped by 0.3% over the year prior. During this timeframe, the return on stocks was essentially flat. However, if earnings undergo another year over year decline next year, the market may not fare nearly as well. This is because global central banks were busy printing nearly a trillion dollars’ worth of QE during the last earnings recession in order to pump up asset prices. In sharp contrast, during 2019 the amount of money printing, on a net global basis, is projected to become negative.
Such a dramatic plunge in asset prices should come as no surprise. What other possible outcome could be expected given that global central banks printed $14 trillion ex-nihilo in order to manipulate every major asset class into an unprecedented bubble. But, now inflation has forced them to reverse course on monetary policy or risk having long-term interest rates spike out of control. Investors should already have their portfolios prepared for the third collapse of equity prices since the year 2000.
Michael Pento is the President and Founder of Pento Portfolio Strategies, produces the weekly podcast called, “The Mid-week Reality Check”, is Host of The Pentonomics Program and Author of the book “The Coming Bond Market Collapse.”