Is the upcoming earnings season a threat to the current bull market?

Earnings for the fourth quarter of 2017 are due to start rolling in over the next few weeks, and they will include a lot of forward-looking estimates for 2018 as well. This can be a volatile time of year when estimates and reports matter more than usual, and there are a few things that could cause some problems.

Estimates are High

Estimates are that earnings per share (EPS) will be up 8% or more across the S&P 500 compared to the first quarter last year, and revenues should be up almost 7%.

This kind of growth after a relatively good first quarter in 2017 is surprisingly strong, and there is some risk (although minor) that — if actual results miss — the good news that has been priced in will come out and the indexes will drop.

Future Estimates Are Even Higher

EPS growth-rates last year peaked at 13.5% in the first quarter, which puts this quarter’s estimates in perspective. The second and third quarter in 2017 were also very strong, and that makes estimates for the first and second quarter of 2018 (9.8% and 10%, respectively) a high hurdle. We don’t think earnings will contract in 2018, but the higher estimates get, the more risk there is for a disappointment to kick off a correction.

If forward-looking statements from management don’t match future estimates, we could see some volatility in late January.

Accounting Adjustments Could Be Misunderstood

The tax bill was a real positive (at least in the short term) for most stocks. However, it also requires an adjustment to the value of Deferred Tax Assets (DFA) recorded on balance sheets. This is an intangible asset that isn’t generated by sales or profit margins, but it’s important anyway. Banks and manufacturers tend to have large DFAs and will have to reduce the value of those on their balance sheets because they will be paying fewer taxes in the future. Sounds good, right?

The problem with reducing the value of an intangible asset is that you must count that as a loss, which will reduce EPS numbers artificially. Although cash-flow will remain the same, EPS could take a hit, and it’s not clear yet whether analysts are fully up-to-speed on the effect of the tax bill on the banks and other sectors with large DFAs.

Investors have been misled by smaller issues in the past, so we will be very interested to see how traders respond when the banks start reporting this week.

Consumer Discretionary Could be a Distraction

Margin troubles, online competition and low levels of inflation have reduced estimates for the consumer discretionary sector. EPS growth on a year-over-year basis in this category could wind up being negative for the fourth quarter of 2017.

This isn’t the biggest risk, but consumer stocks and tech have both had a surprisingly negative relationship with interest rates lately, and volatility could get worse if sales and EPS numbers aren’t better than expected.

The Bottom Line This Earnings Season

Estimates are high and so are valuations. Over the last century, the average price-to-earnings (P/E) ratio for the S&P 500 has only been higher than it is now when a recession was just around the corner.

That sounds bad, but if we adjust the P/E ratio for low interest rates, it’s not quite as bad as it looks. However, valuations and expectations are high enough that the list of reasons the market may correct is growing. Higher interest rates, deferred tax assets and poor performance in consumer discretionary stocks are all factors that should be watched very closely when earnings season begins this Friday.

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