September 5, 2018

Most investors are well aware that the stock market is a forward-discounting mechanism that trades more on forward guidance than on current financial performance. A company can put up huge quarterly numbers and blow out all the Wall Street estimates, but if it guides down sales and/or earnings for the upcoming quarter or full year, its stock gets crushed. That’s just the way it is, and we all have been on the receiving end of this good news/bad news quarterly release whipsaw. Investing is subject to the dynamic psychology of perception versus reality, and much of the time perception wins out.

As of the end of August, investors’ perceptions of forward market conditions are nothing short of ebullient. Capital flows into U.S. equities seem unquenchable with the heavyweight favorite (tech stocks) charging to new all-time highs. Euphoria is running high for the U.S. stock market, now considered the only game in town relative to global investing. All the right things to keep the rally in an uninterrupted run are falling into place. That has caught many fund managers underinvested and aggressively upping their equity weightings so as to at least keep pace with the major averages.

When bullish perception and bullish reality converge, as they have in the present investing landscape, the animal spirits can be unleashed. Third-quarter GDP is set to top 4% again, core inflation is holding at the Fed’s 2% target rate, the yield on the 10-year Treasury is camped out below 3%, and the dollar has pulled back on a narrative that further Fed tightening may cease in 2019 and quite possibly after the September 26 FOMC meeting. Translated, we should expect a year-end rally – which may already be under way.

What is most impressive is that the rally is broad-based, evidenced by strong weekly rotation from sector to sector with technology and consumer discretionary stocks outperforming the other nine market sectors. The current market rally is grounded on solid earnings growth. According to the latest FactSet Earnings Insight (August 31, 2018), 99% of the companies in the S&P 500 have reported results for the second quarter, with 80% reporting a positive EPS surprise and 72% a positive sales surprise.

Sure, tax reform can juice up earnings, but there is no substitute for strong top-line revenue growth. The year-over-year revenue growth rate for Q2 2018 was 9.9%, marking the highest growth rate reported since Q3 2011 (12.5%). Business investment and consumer spending are stoking investor confidence.

The second-quarter numbers were historic. For Q2, the blended earnings growth rate for the S&P 500 was 25%, marking the second highest earnings growth since Q3 2010 (34.1%). Spending by businesses on technology and automation led the way. For Q3, analysts currently expect earnings to grow 20.3% and revenues 7.7%. That will likely prove conservative, as have both the first- and second-quarter estimates.

The chart below tells a bullish story for the S&P 500 in that while the market is trading at all-time highs, earnings are robust enough to maintain a forward P/E for the market of around 16.5 times earnings, which is slightly above fair value but not overvalued relative to double-digit earnings growth. Stocks are moving higher in tandem with earnings growth and with the analysts currently expecting earnings to grow near 20% for the rest of 2018, the prospect of the S&P 500 trading to 3,000 by year-end is quite good.

Graphs are for illustrative and discussion purposes only. Please read important disclosures at the end of this commentary.

Aside from positive economic fundamentals, there is a huge volume of global liquidity seeking total return from both growth and dividend income in a place where the underlying currency is stable, interest rates are leveling off, with tame inflation, a proactive tax policy, and full employment, in a place known for its robust consumer spending – which accounts for 70% of GDP growth. That place is the USA!

The Pendulum Swings in Favor of Dividend Growth in 2019

According to FactSet, the same universe of analysts that are forecasting torrid third- and fourth-quarter earnings and sales growth for the S&P are also predicting a decidedly lower rate of earnings growth and a gradually slower rate of top-line growth for the first two quarters of 2019. The lower EPS figures noted below suggest that 2019 year-over-year comparisons simply aren’t going to be anywhere near what they are for 2018, when tax reform boosted EPS well above the previous year’s slower economic expansion.

(Source: FactSet Earnings Insight)

Granted, these are forward-looking predictions, but assuming growth slows to a sustainable 3%+ rate for GDP in 2019, that is still a golden backdrop for equities, as it implies a stable dollar, low inflation, low interest rates, and full employment. However, the numbers also foretell of a grand shift from market-leading pure growth stocks to blue-chip dividend growth stocks in 2019.

FactSet isn’t alone. The latest data from the Atlanta Fed shows another downtick in their GDPNow model estimate for real GDP growth in the third quarter of 2018. They now see 4.1% growth, down from 4.6% on August 24. I’ve noted recently a softening in housing and auto data. The lower figure is attributed to a decline in exports and real gross private domestic investment growth, declining from 16.1% to 15.5%.

Graphs are for illustrative and discussion purposes only. Please read important disclosures at the end of this commentary.

GDPNow is not an official forecast. Rather, it is best viewed as a running estimate of real GDP growth based on available data for the current quarter. There are no subjective adjustments with GDPNow. The estimate is based solely on its components, and while these data points show a tapering of stellar growth, the data also support sustained economic expansion and a compelling case for dividend-paying stocks.

Last week, I highlighted some softer data in the housing and auto markets, and now we’re seeing some adjustments to GDP and S&P sales and earnings. Bear in mind, these are all positive developments. A tempering of growth keeps current market conditions in place and is feeding the bullishness narrative.

The point I want to make is that a mild downshift in growth usually invites a massive shift into dividend growth stocks. Timing the market’s rotation from pure growth to dividend growth stocks will be the subject of a lot of chatter in the weeks ahead, but I would argue that it is already starting to happen.

About The Author

Bryan Perry

Bryan Perry

Bryan Perry is a Senior Director with Navellier Private Client Group, advising and facilitating high net worth investors in the pursuit of their financial goals.

Bryan’s financial services career spanning the past three decades includes over 20 years of wealth management experience with Wall Street firms that include Bear Stearns, Lehman Brothers and Paine Webber, working with both retail and institutional clients. Bryan earned a B.A. in Political Science from Virginia Polytechnic Institute & State University and currently holds a Series 65 license.


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