excerpted from the March investment comments by Provident Investment Management
So far, 2019 has been kinder to investors than was the finish to 2018. A combination of stronger-than-expected earnings, a more accommodative Federal Reserve, and a strong labor market has supported the full recovery from December’s 9% loss for the S&P 500.
On the earnings front, results are coming in better than expected. According to FactSet Earnings Insight authored by John Butters, fourth-quarter 2018 earnings are projected to grow 13.3% for firms that make up the S&P 500 index. This is a fairly solid reading, as 66% of companies have already reported. If this earnings growth rate holds it will mark the fifth consecutive quarter of double-digit earnings growth for the index.
Unfortunately, the expectations for earnings growth in 2019 continue to be cut. During much of 2018, analysts were projecting continued double-digit earnings growth. Now analysts expect 5%, about half the prior growth rate, and much of this is anticipated to come later in the year. First-quarter earnings are projected to contract 1.7%, with tepid second- and third-quarter growth of 1.2% and 2.5%, respectively, before a 9% jump in the fourth quarter.
A big reason why earnings growth expectations have slowed is the weakness of overseas economies, particularly China. To illustrate the impact, FactSet reclassified companies that make up the S&P 500 into two buckets: those firms with international sales less than 50% and those with more than 50%. For the fourth quarter of 2018, those firms with international sales less than 50% grew their earnings 16.6% while those above grew only 8.4%. For 2019 the breakdown is 6.7% and 1.9%, respectively.
Another reason for the earnings growth slowdown is weak commodity prices, particularly in the energy sector. Robust earnings for Phillips 66 and Marathon Petroleum in the fourth quarter helped create a difficult comparison for 2019. As recently as last December, the energy sector was expected to make a positive contribution to 2019 earnings growth, but now this has flipped to a double-digit drag.
The recovery of stock prices coupled with these more moderate earnings expectations has moved the forward-12-month P/E ratio to 15.8, about 4% below the level of the five-year average (16.4) and 8% above the 10-year average (14.6). This valuation level is roughly the same as was experienced back in 2015 and 2016. This seems like a reasonably priced market that now could have some upside if earnings growth outpaces modest expectations.