December 10, 2018 / 12:03 PM / 9 months ago

The next worry for U.S. stocks: shrinking profit forecasts

NEW YORK (Reuters) - The growing ranks of stock market Eeyores now have another reason to stay glum: Next year’s profit picture is darkening fast.

A trader works on the floor of the New York Stock Exchange (NYSE) in New York, U.S., December 7, 2018. REUTERS/Brendan McDermid

Corporate earnings forecasts are eroding as the tailwind from the tax cut fades and as investors worry the U.S.-China trade dispute could upend global commerce more than it already has.

Even after the second correction of the year for the benchmark S&P 500 .SPX stock index, many investors wonder whether share prices adequately reflect risks of slower profit growth.

Emblematic of the recent turbulence, last week the S&P 500 slid 4.6 percent. The previous week it notched its biggest weekly gain in nearly seven years.

Wall Street analysts have slammed the brakes on estimates for profit growth for S&P 500 companies, which had accelerated for much of the year. Two months ago, 2019 profit growth was pegged at 10.2 percent; it is now seen at 8.2 percent, and growing ranks of doubters reckon growth could slow to half that rate or less.

“It may be more in the line of 3 to 4 percent,” said Paul Nolte, portfolio manager at Kingsview Asset Management in Chicago, adding the market has yet to price that in.

“The risk to that estimate is the downside. Right now, the equity market is focused more on trade than they are earnings.”

Morgan Stanley’s outlook warned of more than a 50 percent chance of a “modest earnings recession,” or two quarters of year-over-year profit declines. That last occurred when earnings declined for four straight quarters starting in the third quarter of 2015.

In recent weeks, top strategists at RBC Capital Markets, BNP Paribas and Bank of America Merrill Lynch have forecast 2019 earnings per share growth below the rate compiled by Refinitiv, an aggregate of estimates from analysts covering individual companies.

Among the deepest profit downgrades have been for the technology and communications sectors that had carried the market higher through the latest stages of the bull market.

Tech delivered third-quarter earnings per share growth of 29.2 percent from a year earlier, but the latest forecasts for next year’s third quarter see that plunging to 2.2 percent and averaging just over 4.9 percent for all of 2019. [L1N1YB25L]

The recently formed communication services sector, which includes such heavyweights as Facebook (FB.O) and other social media companies facing increased regulatory scrutiny, is now expected to deliver profit growth of 6.7 percent in 2019, down from an Oct. 1 estimate of 11.6 percent.

“Tech earnings will be there. They’re just not going to lead,” said Alicia Levine, chief market strategist at BNY Mellon Investment Management.

(For a graphic on '2019 S&P 500 profit growth' click tmsnrt.rs/2QohTvG)

SHIFT IN OUTLOOK

Strong earnings and economic growth had helped stocks rebound from steep drops in February and kept most investors optimistic about market valuations. At the time, earnings forecasts were rising fast as companies were ramping up buybacks and spending plans following hefty tax cuts approved by Congress in late 2017.

Near the end of 2018, the bond market has been flashing warning signs about a possible economic slowdown, while investors fret about nagging trade tensions.

Strategists now fear the economy could slow while interest rates are still rising. Federal Reserve policymakers are widely expected to raise interest rates in December for a fourth time this year, but the focus is on how many rate hikes will follow in 2019.

Another concern for stocks: companies have been warning for a couple of months about rising wages eating into profit margins.

Some strategists did cite reduced profit growth forecasts as one of the reasons stocks sold off recently. The S&P 500 is trading at 15.8 times forward earnings compared with 17.3 at the start of October, according to Refinitiv data.

Others said earnings growth, even at a much-reduced rate, will be healthy enough to support the market.

“Where we’re getting to is a healthy, sustainable level from something that was running really very hot,” said Jonathan Golub, chief U.S. chief investment strategist at Credit Suisse Securities. He said analysts also tend to overestimate long-range profit growth, so investors should not be surprised by reduced forecasts.

Semiconductor-related companies including Micron Technology (MU.O), Applied Materials (AMAT.O) and Lam Research (LRCX.O) are the biggest drags on tech earnings estimates for 2019, while DISH Network Corp (DISH.O) is among the biggest weights on communication services, based on Refinitiv data.

Global demand for chips has been slowing, and investors are concerned the U.S. President Donald Trump could enact tariffs on imports of electronics products manufactured in China that are made with chips from U.S. companies.

Technology and communication services stocks have been among the hardest hit this quarter, with the S&P 500 technology index .SPLRCT down more than 14 percent since the end of September.

Reporting by Caroline Valetkevitch; Editing by Dan Burns and David Gregorio

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