Betting against the stock market because of a weak outlook for corporate earnings might not be the best strategy.
The downbeat climate for profits has been one of the bear case pillars, along with the shaky global growth outlook, the continuing trade tensions between the U.S. and China, and some lingering worries that the Federal Reserve might make a policy mistake.
For the first-quarter earnings period, 59 companies thus far have issued negative guidance against just 19 that have been positive, according to FactSet.
But J.P. Morgan strategists contend that a negative earnings outlook does not necessarily translate to stock market losses — with recent history suggesting that equities actually have performed quite well as companies and analysts are trying to tamp down expectations for the future.
"Many believe that one can't buy stocks before earnings stop deteriorating. We continue to disagree with that view," Mislav Matejka, head of global and European equity strategy at J.P. Morgan, said in a research note.
Matejka and his team, which was named the best in their category four years running by Institutional Investor earlier this decade, point to the last earnings recession in 2015-16 as a template for why the bull market can continue after a rough 2018. The firm favors cyclical stocks such as energy and miners over defensives, based on market behavior during previous similar cycles.
During that run, the stock market bottomed in February 2016 even though the negative trend in earnings revisions continued all the way until December. The market rose 20 percent before the earnings outlook began to turn.
J.P. Morgan expects the earnings backdrop to turn positive as soon as the second half of this year.
"If this comes to pass, it should drive the next leg of the current market rebound, as it will be seen as a fundamental confirmation of the upmove that many investors are still holding out for," Matejka wrote. In that case, some of the market's biggest headwinds could become tail winds.
"We looked for supports from a dovish change in the Fed's reaction function, peaking dollar, improvement in the Chinese growth backdrop and positive developments from the US – China trade negotiations," he said.
In fact, the bull market has been characterized by poor expectations for earnings.
Revisions have been in negative territory 64 percent of the time during the period, with stocks positive 60 percent of the time, according to J.P. Morgan. In all, the is up more than 315 percent since March 2009, despite battling against persistently negative views from investors, corporations and analysts.
The J.P. Morgan team is advising clients not to wait until the earnings backdrop changes before adding to equities. On average over the past four negative earnings cycles, stocks started rallying seven months ahead of a reversal, with the average gain 30 percent.
In the fourth-quarter reporting period, companies that have missed earnings estimates have faced a significantly lower market penalty than in previous years.
Companies that missed saw a share price drop of just 0.4 percent on average over the next two days, compared with the typical 2.6 percent decline, according to FactSet, which points out that the penalty for misses is the lowest since the second quarter of 2009, when the market bottomed.
J.P. Morgan points out that multiple companies, in fact, saw major gains the day after a miss.
General Electric had an 11.6 percent gain, Ingenico Group rose 10.5 percent and STMicroelectronics jumped 10.2 percent.