Note: This article originally appeared on April 5th as an exclusive for Zacks Premium subscribers.
Stocks had another positive finish in today’s session. This followed Wednesday’s wild market swings that left the major indexes in the green, but the day had started deeply in the red on growing trade-centric anxieties.
Trade worries have taken center stage for the market at present, with regulatory concerns about technology stocks and uncertainty about the Fed as the other items on the market’s worry list. None of these worries are expected to go away any time soon, though the focus of this note is primarily on the trade issue and what it means to the market.
We can hope that the coming earnings season, which takes the spotlight next week, will offset some of these worries and help refocus attention on the factors that have been pushing stocks higher over the past year.
The administration’s trade policies are well intentioned, aimed as they are on protecting American jobs and interests. But as an OpEd piece by Daniel Henninger in yesterday’s Wall Street Journal argued, the U.S. labor market is running out of citizen workers, with many industries facing worker shortages. The unemployment rate has been 4.1% over the last few months and the consensus expectation is for the rate to tick down to 4% in the March jobs report coming out Friday morning.
What this means is that we will start seeing a 3-handle on the unemployment rate in the next few months, with a number of economists projecting the unemployment rate exiting 2018 at 3.5%, which will be the lowest unemployment rate since the early 1950’s.
I am all for pressuring China for a fair intellectual property regime for U.S. companies, but I am skeptical that a public trade spat is the way to do it. Defenders of the current policy argue that efforts by prior administrations have been unsuccessful primarily because they lacked the punitive muscle employed at present. May be they are right and the negotiations that have gotten underway or about to get underway will get us to desired place.
But it will be a long and torturous process that will linger at least through the summer months, if not longer. And if the negotiations aren’t successful and tariffs do get levied on Chinese goods, then it wouldn’t be pain free for us either.
Academic research suggests that bilateral trade fights don’t end up benefiting either of the two sides; it’s the by-standers and other competing nations that end up benefiting from the spat. For example, it will be Canada, Argentina, Brazil and other nations that will benefit from China imposing tariffs on U.S. goods, particularly agricultural commodities, but China and the U.S. will bear the burden.
I am of the opinion that nothing substantive will come out of this, beyond symbolic concessions, if any. That doesn’t mean it wouldn’t be disruptive for the market, which it will be. For long-term investors, however, these trade-centric worries are nothing more than noise. It will undoubtedly be hard to ignore, but they have to ignore it as it will most likely be a recurring theme over the coming months.
The one potentially offsetting factor that could get the market’s attention off the trade issue is the Q1 earnings season that (unofficially) gets underway with the April 13 earnings releases from Focus List members JPMorgan (JPM - Free Report) and Wells Fargo (WFC - Free Report) . JPMorgan has been a longstanding part of the portfolio, but we added Wells Fargo this week; more on the reasons for adding Wells Fargo a little later.
The Q1 earnings season promises to be the strongest display of corporate profitability in almost 7 years, which should help ease these trade worries. But before I discuss the details of what’s expected in this coming earnings season, I want to briefly touch on the March non-farm payroll report coming out tomorrow. The ‘headline’ jobs number is expected to come in at 175K vs. 313K in February and the unemployment rate ticking down to 4% from 4.1%.
More than the ‘headline’ jobs tally and the unemployment rate, it will be the wage data that will be in focus, with average hourly earnings expected to be up +2.7% on a year-over-year basis. This expected growth pace is about in-line with the pace that has been in place over the last couple of years.
A wage growth number that is in-line with this expected rate or modestly below this level will cheer market participants as they will see the continued stable wage environment as guaranteeing a steady interest rate policy from the Fed.
Earnings to the Rescue
Regular readers know that the corporate earnings picture has been positive for the last few quarters. But the Q1 earnings season promises to be in a league of its own, with growth reaching levels not seen since 2011. The tax cuts have been a big help, but the synchronized global growth environment is a big contributor as well.
One interesting development recently has been the trend reversal on the estimate revisions front. Over the last many years, estimates for the quarter will start coming down as the quarter will get underway. This trend started easing a bit last year, but completely reversed course for 2018 Q1 and the following quarters, as the chart below shows
Please note that not only estimates for Q1 have gone up, as shown above, but estimates for the following quarters have gone up as well.
The chart below shows current earnings growth expectations for the next four quarters contrasted with what is expected in Q1 and what was actually achieved in the preceding 5 quarters. As you can see, the growth trend is expected to materially accelerate in the next two quarters.
Total Q1 earnings are expected to be up +16.1% from the same period last year on +7.4% higher revenues, with 11 of the 16 Zacks sectors on track to achieve double-digit earnings growth. Energy is one of those sectors with strong growth, but earnings growth for the index would still be very strong (+14.6%) on an ex-Energy basis.
The Technology sector whose stock market performance has lately been very weak is expected to have another very strong showing, with total earnings for the sector expected to be up +20.8% from the same period last year on +11.4% higher revenues. Finance, Industrial Products and Basic Materials are some of the other major sectors expected to show a lot of momentum.
Putting it All Together
The trade issue remains a disruptive risk factor for the market that will likely remain with us for the next few months. That said, I don’t envision any material changes coming out of the process. As disruptive as it is, long-term investors will be well-served not to make major investment decisions as a result of the occasional market jitters. This is the type of noise that you have to get used to, at least for some time now.
Thankfully for us, the Q1 earnings season should provide plenty of reassuring news to offset the trade worries. The low-probability risk on earnings front is that expectations have been raised so much that even the 7-year high earnings growth fails to satisfy them. I don’t think that will be the case, but the risk is there.
Focus List Update: We made one change to the Focus List portfolio this week by adding Wells Fargo (WFC - Free Report) .
Wells Fargo shares have struggled since the sales practices scandal came to light in the Fall of 2016, with the stock losing almost a quarter of its value since February 1st this year. Year to date, Wells Fargo shares are down -12.2% vs. -1.9% decline for the Zacks Major Banks industry, +1.4% gain for the Zacks Finance sector and -1.3% decline for the S&P 500 index. Bears on the stock can reasonably argue that these issues tend to linger around for a while that will keep the stock a laggard for the foreseeable future.
While I acknowledge that the ‘clouds’ may not have fully lifted yet and the stock’s very near-term trading behavior will likely continue to reflect the market sour sentiment. But long-term investors, those with the patience to look past the current gloom, can take solace from the company’s best-in-class business franchise and very attractive valuation. The stock is currently trading at 1.86X trailing 12-month tangible book value, the deepest discount in 5 years to the Zacks Major Bank industry’s 2.42X.
Over the last 5 years, the stock has traded as high 2.41X and as low as 1.58X, with a 5-year median of 2.1X. It consistently traded at a premium to the industry up to the Fall of 2016 when the scandal broke, moving in-line the peer group over the following six months and trading at a discount since March 2017.
This may come across as a contrarian call at present, but I feel strongly about its fundamental logic, notwithstanding the inherent timing uncertainty. It will take some more time for the market to come around to appreciate that the worst is behind the company now, but I have no doubt in my mind that we are very close to that stage, if not already there. As mentioned earlier, Wells Fargo will be reporting March-quarter results next week.
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