3Q Earnings Season and Trading Strategy

Earnings Season

We’re getting into 3Q earnings season and it should probably be telling for how the stock market will finish out the year. I agree with Jim Cramer’s analysis in Real Money, “NABAF is back and it's driving tons of stocks higher that you might have thought from the headlines have no business going anywhere but down. Why? Because they reported quarters that were NABAF, my acronym for Not as Bad as Feared and that thesis controlled today's session.”

He concludes, “The doom and gloomsters have controlled the narrative but the CEOs of most of the companies that have reported so far this quarter saw the pain coming and took decisive action. They combined deft technology with tough decisions to yield lemonade from lemons in almost every case except IBM. It's good news for shareholders who haven't been shaken out by the naysayers and it is a reminder that executives saw the weakness coming and adjusted for it before the slowdown occurred.”

According to John Butters at FactSet, the percent of companies in the S&P 500 that have reported results are, on average beating on the top and bottom line compared to the five year average. Analysts are expecting year-over-year earnings within the S&P 500 to contract 4.7%. He notes, “If -4.7% is the actual decline for the quarter, it will mark the first time the index has reported three straight quarters of year-over-year declines in earnings since Q4 2015 through Q2 2016.” This confirms my belief that we have entered an industrial and manufacturing economic recession similar to 2015.

The trend in the 12 month-forward EPS forecasts have deteriorated over the past year and the market hasn’t been able to gain any traction.

But since the start of the 3Q earnings season, the slope of earnings forecasts has improved slightly. If we see this manufacturing recession spread to the consumer and a full economic recession is on the horizon, we will see a dramatic drop further in the slope of EPS forecasts.

This tweet from Julien Bittel, CFA (@BittelJulien) shows a relationship between the 3mo. to 10yr. yield curve and trailing corporate earnings. This certainly casts an ominous shadow over the potential depth of this earnings recession which would surely be a negative for asset prices.

The most recent report from Richard Bernstein Advisors lays out their strategy in the face of the earnings recession. They point out that earnings projections just appear to be too optimistic. They write, “Chart 2 shows that bottom-up earnings expectations (i.e., those derived by aggregating individual company forecasts) have NEVER forecasted a profits recession before one occurred, and current forecasts might be following that historical pattern.”

They also point out that there has been increased deterioration in earnings projections for mid and small cap equities. “Chart 3 (courtesy of Bloomberg based on a Morgan Stanley study) strongly suggests that analysts’ forecasts for large capitalization companies’ earnings may be too rosy. Estimates for small and midcap stocks have begun to fall, and that makes sense because smaller companies tend to be more sensitive to economic cycles. However, larger capitalization stocks’ earnings forecasts are still increasing! The fact that bottom-up forecasts have never predicted a profits recession, that small and mid-cap earnings estimates are falling, and that large cap stocks’ estimates are rising seems to suggest more risk than investors are anticipating.”

3Q19 GDP Projections

Economic growth for 3Q1 have been trending lower. The nowcasting models from the Atlanta and New York Fed are looking for 1.8% to 1.9% GDP expansion for the quarter.

QE (ish)

Despite the softening economic data and earnings deterioration, the market seems to be getting a bullish bias from the recently announced accommodative moves within the Federal Reserve. It appears we have transitioned from a tightening stance (raising the Fed funds target and quantitative tightening) from late last year to an environment of lowering interest rates and reinstating a quantitative easing program into the end of this year. This could be supportive of higher equity prices if the manufacturing recession is short lived and the broader economy starts getting some traction. The chart below from Knowledgeable Leaders Capital highlights the relationship of Total Fed assets against non-borrowed bank reserves scaled by GDP. This should be considered a positive for equity prices – especially cyclical companies that have been out of favor in recent months.

“After all, it’s not what you call it that matters for our purposes as investors, but rather the effect on asset prices. If “Not QE” acts to increase bank reserves – which appears to be the stated goal – then shouldn’t the asset price response be the same as in other periods in which bank reserves were increasing?”

Interesting Observations

Cam Hui from Humble Student of the Markets tweeted out this chart. If the copper to gold ratio has truly bottomed out, then that would be a positive for equity prices heading into the end of the year.

Seasonality

Seasonality favors the bulls into year-end. This chart from Goldman Sachs (via Real Investment Advice) shows the historical trend of equity markets into for final quarter of the year.

The following chart from CNBC shows that seasonality can have an even greater impact on equity prices during pre-election years.

“In 2018, as the market suffered a relentless liquidation culminating in a 20% three-month loss by Christmas Eve, every seasonal rule of thumb failed. Not simply the tendency of stocks to do well in November and December, but more detailed patterns. When the S&P 500 was up at least 10% through September the market “almost always” carried higher through December, etc.

This doesn’t change the fact that the broad sweep of history has shown a general bias toward strength at year end. And, yes, pre-election years have a more pronounced upside tilt (even granting that there just have not been enough presidential elections to make such analyses statistically rigorous).”

Bottom Line: We think that a mix of NABAF this earnings season, an accommodative Fed and favorable seasonality could propel the market to new ATH’s into the end of the year. We are waiting for the S&P 500 to break out of the trading range of the past six months to the upside. If that were to happen, we will increase our equity exposure and increase our portfolio beta to try and capture additional profits for the year.

Update on our core holdings

UnitedHealth Group (UNH) – WSJ “UnitedHealth Group Inc. UNH -0.89% boosted its profit guidance for the year as revenue growth from its health services and insurance units fueled the company’s third-quarter performance. The company, parent of the nation’s largest health insurer, also on Tuesday offered initial comments about its expectations for 2020, which investors closely watch. Wall Street reacted positively to the updates, sending shares up 8.2% on the New York Stock Exchange. The stock had lost about 12% so far this year.”

“For the third quarter of 2019, earnings rose to $3.67 a share, up 13% from the comparable period last year. Analysts were expecting $3.55 a share. Net income attributable to UnitedHealth common shareholders rose to $3.54 billion from $3.19 billion a year ago. UnitedHealth reported an adjusted profit of $3.88 a share, topping analysts’ estimates of $3.75 a share. The company posted sales of $60.35 billion for the third quarter, up 6.7% from the comparable quarter a year ago and beating the $59.76 billion analysts polled by FactSet had expected. Sales for the Optum health-services business grew 13% to $28.8 billion compared with the year-ago period.”

We continue to like UNH for a few reasons. The health care business OptumCare is rolling out nicely with 45,000 doctors in their network. The revenues have been ramping up and the CEO believes it could generate $100 billion in revenues over the next several years. (Business Insider and Forbes). These stocks have been beaten down during the political season and the “Medicare-for-all” plans put forth by presidential candidates on the left. We view this negative sentiment as a buying opportunity as the Medicare-for-all plans may prove too politically unpopular to gain traction. In a recent Kaiser poll (via Business Insider), voters are cooling to the idea of not having a choice in health insurance providers.

In an earnings growth starved market, we think its beneficial to have positions in the portfolio that offer strong growth at the bottom line. UNH has been growing earnings at 17% CAGR over the past five years. They expect 21% eps growth in the 12 month-forward timeframe on 7.5% revenue growth. The company is trading 15x its forward eps forecasts of $16.14 with 3 to 5-year eps growth expectations of 13% annually. If they manage to keep up their momentum, we could see over $23.00 per share in the coming years. If we assume a 15x to 17x multiple we could see an absolute return of 66% over the next three years or 20% IRR.

Another good article on UNH from Business Insider.

CSX Corp (CSX) - (Reuters) - CSX Corp (CSX.O) reported a quarterly profit that topped Wall Street estimates on Wednesday, as cost cuts helped the U.S. railroad offset lower volumes of shipment in its coal and intermodal units, sending shares up about 2%.

The company’s operating ratio fell to 56.8% in the third quarter from 58.7% a year ago. A lower operating ratio means improved profits for railroads.

Costs fell 8% to $1.69 billion in the third quarter ended Sept. 30, driven partly by lower fuel prices.

We think it’s impressive how efficient and nimble CSX has become. They are taking proactive steps towards maximizing service and profitability. They are a very lean railroad. Should the industrial/manufacturing economy show signs of improvement, we believe CSX is leveraged to really capitalize on a turn in the industry.

CSX has been growing earnings at 17% CAGR over the past five years. They expect 12% eps growth in the 12 month-forward timeframe on flat revenues (this will change if the economic recession spreads to the consumer sector). The company is trading 16x its forward eps forecasts of $4.41 with 3 to 5-year eps growth expectations of 12% annually. We could see $6.22 per share in the coming years. If we assume a 16x multiple we could see an absolute return of 51% over the next three years or 16% IRR.

United Rentals (URI) – Stamford Advocate – “United Rentals, the world’s largest equipment rentals company, reported this week growing revenues for the past quarter. Third-quarter revenues increased 18 percent year over year, to about $2.5 billion. Profits came to approximately $391 million, up 17 percent from the 2018 third quarter.”

We are encouraged by the growth in their business (largely through acquisition) and appreciate that they are de-levering the balance sheet. Company guidance calls for $1.45 billion to $1.55 billion in free cash flow through the end of the year and the company reduced debt by $150 million compared to 2018 levels. Management believes it will end the year with a net leverage ratio of 2.6x compared to over 3.0x in 2018.

We believe the corporate debt levels were holding the stock price down and wasn’t truly reflecting the increased business from the BakerCorp and BlueLine acquisitions. Progress on that front was rewarded as URI was one of the best performing stocks in the S&P 500 a day after they reported quarterly numbers.

URI has been growing earnings at nearly 30% CAGR over the past five years (again through acquisition). They expect 21% eps growth in the 12 month-forward timeframe on revenue growth of 4%. The company is trading 6.6x its forward eps forecasts of $20.02 with 3 to 5-year eps growth expectations of 11% annually. We could see $27.00 per share in the coming years. If we assume a 8.5x multiple we could see an absolute return of 75% over the next three years or 21% IRR.

More on URI

Business Wire - United Rentals Announces Third Quarter 2019 Results.

Seeking Alpha - United Rentals' Quarter Proves It Is Worth Owning – AllStar Trader

Trading Ideas

We look for shorter-term swing trade ideas. These are usually companies with strong technical profiles and a recent breakout from an ascending triangle, reverse head & shoulders pattern, cup and handle pattern or a gap higher.

Joseph S. Kalinowski, CFA