Market Insider

Stock market comeback faces big test with earnings season starting

Key Points
  • Earnings expectations for the fourth quarter have been dialed back, and with stocks down about 12 percent from September highs the earnings season could actually be a positive.
  • Strategists say the market could be put to the test when earnings roll out, and companies discuss the first quarter, which is expected to see much slower profit growth.
A trader works on the floor of the New York Stock Exchange (NYSE) ahead of the opening bell, January 4, 2019 in New York City. Following a strong December jobs report, the Dow Jones Industrial Average rose 350 points at the open on Friday morning. In a television interview on Friday morning, National Economic Council Director Larry Kudlow said he believes there is 'no recession in sight.'
Drew Angerer | Getty Images News | Getty Images

Earnings season may not be the club for stocks it could have been had the market not gotten so beaten down.

But it could be a period when the stock market is put to the test, as companies discuss trade, slowing global growth and other issues that have shaken investor confidence.

There have been some high-profile warnings, such as Apple, Constellation, FedEx and Lennar.

Analysts expect that most of the bad news is out on earnings, but if the results and comments are worse than expected, the market could easily retest its lows. On the other hand, if earnings are better than expected, they could act as a positive force to help fend off further declines, strategists said.

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Fourth-quarter reporting season, with major banks releasing numbers next week, will also serve as an important transition period between 2018's strong double-digit profit growth and 2019's much slower single-digit pace.

Earnings are expected to be strong, up 14.7 percent in the fourth quarter, but corporate executives will be discussing the activity in the current quarter, which is expected to see much slower profit growth. First-quarter earnings are expected to be up around 3.9 percent, according to Thomson Reuters.

But analysts say while the expectations have come down sharply for 2019, so have stock prices, and that could provide breathing room.

"We could see continued volatility, but I think the bar is set so much lower with valuations so much lower than going into Q3 reporting," said Keith Parker, chief U.S. equities strategist at UBS. "You've had such an unwind in the fourth quarter. Momentum stocks were unduly punished and there's less of an overhang. You put that all together, and it makes the likelihood of a bust, in our view, much less likely. Our view is we'll probably have more mixed results and guidance going into the quarter, but it does raise the likelihood of relief rallies, given where positions and expectations are."

For the fourth quarter, at least 72 S&P 500 companies have issued earnings warnings, twice as many as have issued positive guidance, according to FactSet. Earnings growth rates have also been revised lower by companies in all 11 S&P sectors. As of September, earnings for the quarter were expected to be up more than 18 percent, but that number has been revised down.

"I think the earnings expectations are low enough that people feel they need to exceed those lowered expectations for Q4," said Sam Stovall, CFRA chief market strategist. "In each of the last 27 quarters, the S&P 500 had earnings that exceeded estimates. So, with the bar having been set lower, I think that investors are expecting Q4 of 2018 to be the 28th consecutive quarter. I think investors are not going to be very forgiving of companies that miss reduced Q4 earnings estimates."

Stovall said 2019 earnings had been expected to be up 10 percent, as of September, but that forecast has fallen closer to 6.5 percent.

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"Stock prices won't get pounded as much for a miss now since we've already gone through corrections or bear markets, depending on what sectors or stocks you're looking at. I think investors will sell off shares of companies if they miss their already reduced expectations," said Stovall.

Tony Roth, chief investment officer at Wilmington Trust, said the earnings season is being overshadowed by issues that are concerning the market, but it could be a positive. "There's a lot more upside than downside," he said. "One thing that's going to temper earnings is the uncertainty around the impact of the federal government shutdown, assuming that continues, and the outlook for trade and tariffs. I think it's unlikely we're going to get a significant miss, but it's very unlikely we're going to get the kind of beat and raise environment we usually get. Companies are going to be very cautious about providing that kind of guidance."

Paul Hickey, co-founder of Bespoke, said positive corporate guidance peaked during the summer, and now fewer companies offer upside guidance than lowered guidance.

Source: Bespoke

Hickey said the market looks set to retest the lows of late December. "It's about seeing how this is going to play out. We're relatively cautious," said Hickey. "I think early on in earnings, over the next week or so, if you start to see positive reactions to companies reporting, you won't get that typical retest you would expect to see."

"If they're bad, we'll see at least a retest of December lows," he said.

Roth said health care should be a strong sector this earnings season.

"I think you will see a good number beats because the consumer was so strong in the fourth quarter. It could be more in discretionary but it could also be in communications services, in financials. You saw rates come down, so there's a little bit of momentum in housing," said Roth.