Banks Supplant Energy in Destroying S&P 500 Growth Outlook

  • Analyst estimates for financials drop the most in four years
  • Biggest profit contributor turning to one of the biggest drags

The two-quarter retreat in Standard & Poor’s 500 Index earnings is about to become a three-quarter swoon, and this time it isn’t just because of plunging energy prices.

Bank profit estimates are falling at the fastest pace in four years, bringing the overall forecast for S&P 500 earnings in the fourth quarter to a decline of 5.6 percent, compared with a gain of 1.4 percent as recently as August. Financial institutions are exerting an ever-increasing drag on analyst projections: what had been expected to be a 16 percent surge in their October-to-December income has narrowed to less than 1 percent.

While the deterioration reflects subdued trading forecasts for some of the country’s biggest lenders, it illustrates a broader truth: that once profits start to decline in one area of the economy, it’s hard to keep weakness from spreading. Now it’s happening to the S&P 500’s biggest earnings contributor at a time when weakening income represents a growing risk to the 6 1/2-year old bull market.

“It’s another sector that is essentially faltering in the face of the economy, which is giving every indication of a further slowdown if not outright recession,” said James Abate, who helps oversee $1 billion as chief investment officer at Centre Funds in New York. “You’re seeing sector by sector starting to basically wither. If you get an environment where earnings continue to drop in a very high-expectation world, that’s a recipe for a difficult, if not a corrective, market.”

Embedded Valuation

Those expectations are embedded in valuations, with the S&P 500 trading at a price-earnings ratio of 18.6, compared with the 10-year average of 16.6. As a precaution against equity losses, Abate’s firm owns options that appreciate should the broader market decline and favors companies whose earnings have shown resilience, such as Inc. and Alphabet Inc., Google’s parent.

The S&P 500 slipped 0.5 percent at 4 p.m. in New York. The index has alternated between gains and losses every day since Nov. 16, something not seen since April 2013.

Earnings in the S&P 500 posted their worst slump since the financial crisis in the quarter that ended Sept. 30, falling 3.3 percent during a stretch that saw stocks suffer their first correction in four years. Banks and brokerages, whose 21 percent share of the index’s profit so far this year tops any other industry, experienced a 6.5 percent income drop.

Financial earnings growth is seizing up after holding firm in the face of oil’s collapse and a strengthening dollar, which pummeled commodity and industrial sales. From Goldman Sachs Group Inc. to Morgan Stanley, estimate cuts are piling up after the Federal Reserve delayed its first interest rate increase in almost a decade and JPMorgan Chase & Co. said in October that analysts’ expectations were too high for the rest of the year.

Estimate Cuts

Doug Sipkin, an analyst at Susquehanna International Group, trimmed his forecasts for Goldman Sachs and Morgan Stanley on Oct. 21, citing concern that the uncertainty over Fed’s interest rate policy will continue to temper trading while widening credit spreads discouraged bond issuance. The same month, Keefe, Bruyette & Woods Inc.’s Chris Mutascio reduced his estimate for JPMorgan, saying the lender’s revenue from investment banking and the card business will drop.

In aggregate, analysts have lowered fourth-quarter profit forecasts for financial firms by $2.5 billion over the past three months, an amount that represents about one fifth of the total reduction in S&P 500 estimates and exceeds all other industries except energy.

“The dramatic change in forecast quarterly earnings growth has to do with the expectations three, five months ago that we would already be in the interest rate hike cycle, which would clearly be a benefit to banks’ net interest margins,” said Hank Smith, who helps manage $8 billion as chief investment officer at Haverford Trust Co. in Radnor, Pennsylvania. “The fact that we haven’t started the process yet perhaps caused analysts to ratchet down.”

Only Group

Banks and brokerages are the only group in the S&P 500 that failed to meet analysts’ expectations in the third quarter as low interest rates and volatile markets stymied revenue growth. They nevertheless earned a combined $172 billion in the first nine months of the year, more than any other industry over the period.

The worst part of the downgrade cycle is probably over and earnings will improve once the Fed starts to raise rates as early as next month, according to Patrick Kaser, a managing director and portfolio manager at Brandywine Global Investment Management. The majority of the profit decline is still concentrated in energy, he said.

“There is fear among investors that this is a spillover, but I think the effect is temporary,” Kaser, whose firm oversees about $66 billion, said by phone from Philadelphia. “For many financial companies, fourth quarter aside, they have pretty decent earnings.”

The profit contraction that started with energy has branched out to encompass about half of the 10 main groups in the S&P 500, including producers of household goods and raw materials. With earnings poised to fall for a third quarter, investors are facing a stretch of declines that has historically proved hard to stop.

Among 17 profit recessions that have lasted nine months since the Great Depression, only one stopped there, in 1967, data compiled by Bloomberg and S&P Dow Jones Indices show. The others dragged on, spanning five quarters on average.

Analysts anticipate earnings will rebound, with S&P 500 profit climbing 7.1 percent in 2016 and 12.5 percent in 2017, according to estimates compiled by Bloomberg. The acceleration contrasts with economists’ predictions that show U.S. gross domestic product will be stuck at an annualized rate of 2.5 percent amid the weakest recovery since World War II.

“We’re in an environment where a lot of companies are having a hard time growing their top line,” said Don Townswick, director of equities at Hartford, Connecticut-based Conning Inc., which manages $92 billion. “Analysts hold on as long as they can, trying to keep their numbers and targets up. As they realize their targets for the year are too rosy, the lower tide will lower all ships.”

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