Markets

Weak 2019 earnings growth paves the way for a strong 2020 earnings picture, boosting stocks

Key Points
  • The Dow Jones Industrial Average, S&P 500 and the Nasdaq hit all-time record highs on Thursday, boosted by an interest rate cut from the Federal Reserve and U.S.-China trade optimism.
  • Another factor propelling the latest rally is the weak earnings growth in 2019 that will pave the way for a solid 2020 earnings picture.
  • "Markets rallying to new highs clearly indicates that marginal investors believe 2019's no-growth earnings will make for easy comps in 2020 if the US-China trade war abates," said Nicholas Colas, co-founder of DataTrek Research.
Traders work after the opening bell at the New York Stock Exchange (NYSE) on August 15, 2019 at Wall Street in New York City.
JOHANNES EISELE | AFP | Getty Images

Earnings in 2019 are setting a low bar to clear in 2020, paving the way for stocks to continue their record-setting rally, according to Wall Street strategists.

Third-quarter earnings are slated to see a 2.4% drop from last year's third quarter, according to DataTrek Research. The first and second quarter saw 0.4% declines in earnings from the same periods last year. Plus, the fourth quarter is looking like another tough quarter with analysts estimating a 1.1% fall in earnings from 2018.

"Markets rallying to new highs clearly indicates that marginal investors believe 2019's no-growth earnings will make for easy comps in 2020 if the US-China trade war abates," said Nicholas Colas, co-founder of DataTrek Research, in a note called "2020: The Year of Easy Earnings Comps."

The Dow Jones Industrial Average, S&P 500 and Nasdaq hit all-time record highs Thursday. A rate cut from the Federal Reserve a week prior and trade war optimism between the U.S. and China contributed to the stock market surge. Another factor propelling the latest rally is the weak earnings in 2019 that will pave the way for a solid 2020 earnings picture.

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As forward earnings estimates have fallen since the start of October, stocks have rallied. Analysts expected 3% earnings growth in the fourth quarter on Oct 1. Driven by weakness in large caps like Alphabet, Boeing, Exxon Mobil and Micron the earnings growth estimate has fallen to zero.

For the third-quarter, Google's parent company reported earnings of $10.12 per share, compared to the $13.06 per share earned in the same period of 2018. Boeing reported a more than 50% slide in third-quarter profit, as the aerospace giant maker struggles to recover from two fatal crashes of its top-selling 737 Max aircraft. Exxon Mobil reported a 49% drop in third-quarter earnings on lower oil prices and higher costs. And chipmaker Micron saw a 39% decline in revenue from last year, weighed on by the U.S.-China trade war.

Given this weaker data, analysts are estimating EPS to be flat year over year, according to Bank of America. In that time, the S&P 500 has gained nearly 4%.

"Commentary on earnings calls has suggested weakening trends, but optimism is building," said Bank of America equity and quant strategist Savita Subramanian in a note to clients.

Earnings growth for 2020 has fallen to its lowest estimate in all of 2019, DataTrek Research noted. At the end of the second quarter this year, Wall Street estimated 12.9% earnings growth for 2020. That has fallen to 9.9%. And Goldman Sachs expects estimates will come down further to about 6% growth in 2020. But the firm said this trend is not problematic for stocks.

"Looking into 2020, although consensus expectations for 9% EPS growth appear too optimistic, modest negative revisions should not pose a major risk to the market," said David Kostin, chief U.S. equity strategist at Goldman Sachs.

Kostin said due to China tariffs still in place, 2020 earnings revisions in its China exposure basket have been among the most negative.

What does this mean for valuations?

While earnings per share expectations have fallen and stocks have rallied, valuations have faltered, according to Nick Raich, CEO of The Earnings Scout.

"Relative to the direction of overall S&P 500 EPS expectations, stocks have become overvalued," said Raich. "Stock prices are now expensive."

Based on 2020 estimates, the S&P 500 currently trades at 17.12 times earnings, up from last week's 16.96 times earnings, the firm noted.

"We have seen the S&P 500 climb back to a new all-time high as the rate of change to EPS expectations has improved, but not quite as much as the underlying improvement would suggest," Raich said.

— With reporting from CNBC's Jeff Cox and Michael Bloom.