US stocks have been stuck in a rut for the last few months, unable to break out of their narrow trading range as investors weigh the potential damage to corporate earnings from tit-for-tat tariffs with China and a sharp fall in confidence among domestic manufacturers.

Thanks to the trade war, a strong dollar – which hurts US exporters – and an unusually strong third quarter last year, earnings for S&P 500 companies are expected to shrink the most in more than three years in the three months to September.

However, a study of past earnings reports suggests that fears could be overdone as companies may have set the bar deliberately low in order to beat their own guidance.

EARNINGS HEADWINDS

The S&P 500 index had a stellar start to the year, gaining more than 17% to the end of April, but since then it has failed to make much headway and seems stuck in a range between 2,800 and 3,000 points.

At the same time, earnings growth forecasts have been pared back. For the three months from July to September, earnings per share for the S&P 500 index are now seen falling by 3.8% according to data provider FactSet. This compares with a drop of 0.3% in the first quarter of 2019 and a drop of 0.4% in the second quarter.

If earnings do fall in the third quarter it will be the first time since the ‘profits recession’ of 2015-16 that the index has seen three straight quarters of earnings decline.

As well as the impact from tariffs and the trade war, a strong currency is hurting US exporters as their foreign earnings are worth less once they are translated back into dollars.

Industrial, material and energy stocks have seen their earnings forecasts cut the most during the past quarter. Earnings forecasts for the material and energy sectors have been cut by 12.4% and 17.5% respectively during in the last few months.

Digging deeper, nearly 90% of energy stocks in the S&P 500 index have seen their third quarter earnings estimates reduced in the last three months.

Meanwhile, industrial stocks are at risk not just from the trade war but from a sharp fall in US manufacturing confidence. The Institute for Supply Management’s monthly purchasing managers’ index released at the start of this month registered its lowest reading since the end of the financial crisis in 2009.

Another factor behind the lack of earnings growth this year is that profit growth in 2018 was well above historic norms, averaging over 20% in each of the first three quarters (as shown by the chart), boosted by one-off tax breaks handed out by president Trump to US companies.

EARLY REPORTS ARE POSITIVE

Among the first companies to report earnings last week were banking giants Bank of America, Citigroup, Goldman Sachs and JPMorgan. The results were mostly favourable, with Bank of America, Citigroup and JPMorgan beating forecasts while Goldman Sachs disappointed.

Collectively banks are expected to report a 1.2% decline in earnings, their first year-on-year drop in three, due to low interest rates and lower demand for corporate borrowing.

Also reporting last week were major healthcare stocks, which are generally more resilient to economic conditions. Johnson & Johnson and UnitedHealth both beat forecasts and raised full-year guidance, sending their shares sharply higher, while Abbott Labs met forecasts.

A key sector to watch is technology as a record number of tech companies issued negative earnings guidance in the last quarter. No fewer than 29 firms lowered their third quarter earnings forecasts, the highest number since FactSet began tracking the data in 2006.

Investors will also no doubt be keeping a close eye on the newly-listed ‘unicorns’ like Snap, Lyft and Uber to gauge whether their earnings justify their stock market valuations.

GAMING THE SYSTEM

It’s important to note though that when companies lower their earnings guidance, it makes it easier for them to beat these reduced expectations.

While the process of what’s known as ‘walking down forecasts’ in order to beat them isn’t strictly against stock market rules, the number of companies now employing this tactic – including some of the biggest names in the US – shows that meeting or beating short-term earnings targets has become almost a goal in itself.

FactSet reports that of the 113 companies in the S&P 500 issuing earnings guidance during the last quarter, 82 lowered their forecasts while just 31 raised their forecasts.

This led analysts to lower their third quarter growth forecasts for the index as a whole by 3.6% during the quarter. On average, analysts have reduced their forecasts by 3.3% each quarter over the last five years so a 3.6% cut isn’t overly negative.

Also, over the last five years actual earnings reported by S&P 500 companies have tended to beat estimates by around 5% each quarter, with more than 70% of companies typically reporting an ‘earnings surprise’.

All of which means that, despite market worries about weak US earnings, if history is any guide earnings should come in ahead of analysts’ estimates if for no other reason than the bar has been set very low this time round.

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