Stocks closed mixed yesterday. The highlight of the day, the somewhat formal start of earnings season, was the report of fourth quarter results from three of the four largest banking institutions. The results were mixed with JPMorgan Chase# reporting much better than expected results thanks to very strong fixed income trading while Wells Fargo continued to disappoint.
The big news today is the expected late morning signing of what has been labeled Phase I of a negotiated trade agreement with China. The agreement expands expected purchases of U.S. goods by China, some incremental enforcement actions to protect U.S. intellectual property, and new rules that will open up Chinese markets for U.S. financial institutions. The Chinese get some tariff relief and promises of no future tariffs as long as they abide by rules of the agreement. Separately, the Trump administration is looking to tighten restrictions on the ability of U.S. companies to sell products to Huawei, the big Chinese telecom equipment firm. The general view is that this agreement is a small step forward and it serves to calm tensions of further trade escalation. At the same time, it is unlikely to move the overall economic needle. If the Chinese buy all the agricultural products promised in the deal over the next two years, it will be a help to farmers. But the uncertainties remaining and the tensions likely to persist will continue to push U.S. companies to continue to diversify their supply chains away from China. Those decisions would be independent of who our next President might be. The consensus of the moment suggest ongoing economic confrontation between the two nations will continue regardless of who might be elected.
Speaking of the election, the Democrats had another of their endless debates last night while President Trump was holding yet another of his rallies to fire up his base nearby. Nothing substantive came out of either event and only the cable news media will waste time today discussing either event. Staying with politics briefly, the Senate is moving closer to the actual impeachment trial as both sides bicker on rules. But the American public appears tired of the whole process and the outcome still seems rather certain. Again, none of this is impacting financial markets and won’t unless there is a dramatic turn of events.
That means earnings are about to take center stage with the real crescendo starting next week and continuing until early February. That companies will beat consensus expectations as they report isn’t in question. Corporate managements have become masters in manipulating Wall Street analysts toward forward looking forecasts that can be achieved. But there are big differences between what I will call beat and lower versus beat and raise. Let me explain.
Beat and lower is what happened all last year. Companies regularly beat published estimates while, at the same time, lowering future expectations. If future forecasts are lowered by more than the better than expected performance of the quarter just reported, the net result would be lowered earnings guidance for the quarters or year ahead. Indeed, while corporations beat earnings forecasts in every quarter in 2019, overall corporate profits actually declined. On a per share basis, they rose slightly thanks to stock buybacks, but 2019 was not a banner year for corporate profits.
Beat and raise is a totally different animal. The message here is that good results from the most recent quarter motivates management to raise future expectations. This is what investors want to see. The companies that were able to do this regularly have almost always been rewarded with a higher stock price. The one exception, and it is worthy of noting, is that sometimes investor optimism about a stock (and valuation) can be so excessive that a beat and raise event may not be enough to raise prices further.
As I note often, earnings season isn’t about absolute results; it is about performance versus expectations. Expectations are what are built into stock prices. It is the change in expectations that result in price movement. That is why beat and lower can be so damaging.
I just mentioned that occasionally expectations are so high that a company simply can’t, despite a beat and raise quarter, beat what investors have already factored into the stock price. In that case, either the stock has to fall back a bit to allow fantasy to meet reality, or it has to tread water for a while until growth catches up and valuation returns to some sense of sensibility. There is the opposite extreme to note as well. Sometimes investors can get too pessimistic. Bad results and lowered forecasts do not always mean a lowered stock price if too much pessimism is already built in. Stocks that don’t go down on bad news could signal a bottom but only if fundamentals begin to turn. A company that endlessly disappoints is headed toward zero even if there is a momentary reprieve.
I want to make a case in point by discussing the auto industry. One stock on a tear recently has been Tesla. In fact, its valuation has gotten so high that it is now worth more than General Motors and Ford combined! Before you jump to conclusions, I am not about to make any comment on the investment merits, good or bad, about Tesla. What I can say is that (1) it is clearly a disruptive force in the auto industry, (2) it makes a car that its owners love, and (3) production is finally accelerating, particularly in China, to a point where it can make money. Whether it can ever make enough money to justify its stock price is another question that I can’t answer. But for this discussion, I want to focus on the other two, General Motors and Ford. They are the disrupted. While both are spending a lot of time and money to get into the right areas like electric cars, both are moving in the right direction so slowly that they are more and more being left behind. Of the two, Ford looks to be the big laggard. Sales in China, the world’s biggest auto market, are down 20%. No one is going to make money buying a company with falling sales.
Wal-Mart’s# stock valuation sailed by Sears long before it took sales leadership. Now Macy’s is floundering and closing more stores. It has become the Ford of retailing. Indeed, across our economy, you can find old names that are steadily losing share. Some are still able to grow a bit but, if they fall further behind, they will stop growing and fade away. IBM# reports fourth quarter results on Monday. It hopes the recent purchase of Red Hat will finally give it the momentum needed to reaccelerate revenue growth. Indeed, 2020 will be a pivotal year for IBM. Its legacy businesses are in decline. Its savior is a large hybrid cloud opportunity which it needs to latch onto aggressively if it has any chance of remaining a major tech player. That opportunity is now, and it won’t be there forever.
The consensus is that the U.S. economy is starting to rebuild momentum. If that is true, it should be reflected in greater optimism as managements report fourth quarter results. If that is true, stocks can grind higher. If managements fail to display renewed optimism, it could be the seed for a correction.
Today, Pitbull is 39. Shane McMahon turns 50.
James M. Meyer, CFA 610-260-2220