The two things that move stock markets are interest rates and earnings. With the Federal Reserve on hold for rate increases, that means earnings growth will be increasingly important in setting share prices.
That’s been a winning strategy so far. From the end of 2016 through last Dec. 31, earnings per share for S&P 500 companies probably rose about 40% — the same amount the S&P gained from just before the election through its October 2018 all-time high.
In fact, the companies in the S&P SPX, +1.09% just completed three consecutive quarters of 20%-plus year-over-year earnings per share growth. Fourth-quarter earnings are on track for a 13.2% gain, according to FactSet Research, a streak of double-digit earnings growth that goes back to the fourth quarter of 2017.
After that, things may go south: FactSet reports analysts are projecting a 1.9% decline in S&P earnings in the first quarter, followed by increases of 1.1% in the second quarter, 2.4% in the third and 9% in the fourth for overall 2019 EPS growth of 5%.
That fourth-quarter 2019 estimate will almost certainly be cut, as analysts are pretty clueless about what will happen six weeks from now, let alone in almost a year. They’re also knee-jerk optimists who find it constitutionally difficult to even think anything “negative” about the stocks they follow—until they have to hastily cut their rosy projections.
As my MarketWatch colleague Sue Chang wrote this week, Morgan Stanley’s bearish chief equity strategist Mike Wilson has downgraded his 2019 forecast to a mere 1% EPS growth and wrote, “our earnings recession call is playing out even faster than we expected.”
Meanwhile, stocks are going gangbusters, as if there was going to be 20% earnings growth as far as the eye can see. But sooner or later investors will realize they’re paying more and more for less and less earnings. At that point, interest rates, trade wars and government shutdowns aside, the best-performing stocks will be those that post the best earnings.
Which ones will they be? I spoke with FactSet’s chief earnings analyst, John Butters, to sort it out. He doesn’t pick stocks or sectors but he does track earnings trends. Here are some of them.
Among the S&P 500 companies, those that do most of their business in the U.S. are easily beating those that get the lion’s share of sales overseas. Companies that get more than half of their revenue from the U.S. have seen their earnings grow by more than 16% in the fourth quarter, while those that get more than half their sales from abroad are growing by slightly more than 8%. In 2019, FactSet calculates, analysts expect earnings of domestically oriented S&P 500 companies to grow more than three times as fast as those of internationally focused firms.
Butters attributes that to a stronger U.S. dollar and weakening overseas economies, both of which increase the relative attractiveness of the domestic U.S. market.
Not surprisingly, the iShares Russell 1000 Pure U.S. Revenue ETF AMCA, +0.91%which invests in companies that derive at least 85% of their revenue from the U.S. market, rose 16.6% from the market’s Dec. 24 low through Wednesday, easily topping the S&P, which gained 11.2% over that period. (The S&P beat AMCA slightly over the last two and five years, however.) AMCA’s three largest holdings, as of the end of 2018, were U.S. stalwarts Berkshire Hathaway Class BBRK.B, +1.24% UnitedHealth Group UNH, +2.19% and Verizon CommunicationsVZ, +2.09%
At my request, Butters also identified the sectors where earnings growth was strongest. Energy knocked it out of the park, posting year-over-year fourth-quarter gains of more than 98%, followed by the new communications services sector, which had nearly 22% EPS growth, and industrials, whose companies have reported year-over-year EPS gains of more than 18%.
Read: Michael Brush on 6 easy ways to reach for ‘safe’ dividend yield with energy stocks
Again, not surprisingly, the Industrial Select Sector SPDR XLI, +1.34% has been the best performing S&P sector ETF since Dec. 24, notching a gain of more than 24% through Wednesday’s close. Two other Select Sector SPDR ETFs, focused on energy XLE, +1.61% (up around 19%) and communications services XLC, +0.43% (up 17.6%), were among the top five sector performers during that time.
Last week, this column identified energy, industrials and communications as classic late-cycle outperformers as the economy moves into the final stage of the business cycle.
According to Butters, analysts are looking for health care, industrials and utilities to lead the pack in earnings growth in the first quarter of 2019 and industrials, consumer discretionary stocks and financials to set the pace for all of 2019.
Read: 20 companies with zooming sales and fattening margins that can power their stocks forward
As I said, a lot could change by the end of the year, but to me the message of this earnings season is loud and clear: get domestic and get defensive.