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Season's Greetings

Earnings season that is. Earnings season kicked off last week and it has indeed been the “hap, happiest time of the year” for stock investors. Investors have been drinking earning’s eggnog spiked with a little extra Q4 corporate revenue. It’s been a lot of fun partying it up this earnings season. As always, it’s important to know when you’ve had enough, and avoid the pain that the day after can bring. After a dismal December, stocks bottomed on Christmas Eve, down 19.8% from their all-time highs. As of Friday's close, stocks had bounced 16.2% since the December 24th low. The S&P 500 is up 9.73% YTD and currently is 6% below its September 20th all-time high.

The Fed certainly helped out stock investors by indicating a pause in fiscal tightening, but a strong earnings season has been the bigger story. Nightly news stories about the imminent economic recession have been spooking investors for quite some time, the problem is someone forgot to tell corporate America. Before we start reviewing the Q4 earnings season, let's first talk about an amazingly strange but consistent tendency earnings analysts have displayed over multiple earnings seasons dating back many years. Analysts have a tendency to be too optimistic well before earnings season. As earnings season approaches, they become more realistic and start cutting their estimates. Then right before earnings are released, they usually become too pessimistic, and lower estimates further. This leads to companies usually beating these more cautious estimates.That’s what is happening this season too, however the “beats” are bigger than usual. Perhaps more importantly, forward guidance from corporate management is strong. They are not seeing the recession that so many economists keep promising us. Analysts have been raising their estimates for both 2019 and 2020 revenue growth.

Analysts estimate revenue growth rates of 5.5% this year and 5.0% next year. Last earnings season, before the Q4 stock market sell-off, analysts were projecting 5.2% and 4.1%, respectively. They’ve also raised their 2020 earnings estimates from 10.3% last quarter to 10.9% this quarter.

Allow us a couple of paragraphs of boring but important numbers and observations. Forward revenues are highly correlated with actual revenues. Forward revenues rose to record highs in January. Forward earnings are also highly correlated with actual earnings. Forward earnings rose to a record high of $175.48 per share during January. What's strange is that analyst earnings estimates for 2020 and beyond keep falling. Something has to give for this mathematical equation to be true. That something is that analysts must believe profit margins will fall. Profit margins rose to a record high of 10.9% in 2017 before the corporate tax cut (TCJA) in December. After the tax cut, profit margins jumped to another record high of 12.5%.

Forward profit margins were down to 12.1% during this latest earnings season. Consensus estimate for the 2019 profit margin have dropped from 12.4% last year to 12.0%. The 2020 estimate have dropped from 13.1% to 12.7%. If revenue forecast are increasing, and earnings forecasts are decreasing, it must mean analysts see corporate costs also increasing, and therefore shrinking profit margins. We understand their reasoning given the perceived tightness of the labor market. Labor is the biggest cost to corporations. A tight labor market has historically meant higher wages. That said, we disagree that labor costs will spike higher. We continue to believe the labor market is not as tight as many economists believe. As we've mentioned several times before, we believe technology and globalization have and will continue to keep wage costs and inflation lower than traditional forecasting models, like the Phillips Curve, would indicate. Additionally, as wages and job openings have increased, we have also seen an increase in the labor force participation rate, as working becomes a more appealing option than staying at home. Markets are forward looking. Current rates of inflation are less important than future rates of inflation. That's why despite current low levels of inflation, analysts believe future profit margins will shrink. They believe future inflation will be higher. We object your Honor. For our last witness we will call the 10 Year TIPS (Treasury Inflation Protected Security) Yield to the stand. TIPS are securities indexed to the inflation rate. The difference between the yield on the 10 Year TIPS Note and the traditional 10 Year Treasury Note is the implied average rate of inflation for the next 10 years. Currently that rate differential is 1.87%. That's what the the real money is betting. Much like football analysts have many opinions about who will win and why, the Vegas betting line is the real money, and has proven to be the best predictor of who will win.

While we are at odds with many economists and analysts about future inflation rates, the "real" money seems to be betting on the lower inflation scenario. We will continue to monitor for any signs of inflation, as of now, we don't think that train is coming anytime soon. Congratuatlions to our 6 time Super Bowl Champion New England Patriots, The GreenPort Team

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