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What's up? Volatility and earnings

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The views expressed in these posts are those of the authors and are current only through the date stated. These views are subject to change at any time based upon market or other conditions, and Eaton Vance disclaims any responsibility to update such views. These views may not be relied upon as investment advice and, because investment decisions for Eaton Vance are based on many factors, may not be relied upon as an indication of trading intent on behalf of any Eaton Vance fund. The discussion herein is general in nature and is provided for informational purposes only. There is no guarantee as to its accuracy or completeness. Past performance is no guarantee of future results.

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      By Yana S. Barton, CFA, Portfolio Manager, Growth Team, Eaton Vance Management and Lewis R. Piantedosi, Director of Growth Equity, Eaton Vance Management

      Boston - The month of October has not been kind to equity investors, with the S&P 500 Index on pace for a monthly decline of more than 8%, the worst October showing in over 10 years. The recent sell-off has been blamed on a myriad of anxieties around global trade, inflation, interest rates and elections.

      But don't forget, the stock market is considered to be a discounting mechanism, anticipating the impact of future events and adjusting accordingly. Earnings have historically been the best gauge of future prices, so it's no surprise that investors are watching corporate results for insights into the past quarter and for clues into 2019. Slower growth is on the horizon, but is not a precursor of the bull market's end.

      Our early take on Q3 results

      As of this writing (Oct. 24), approximately 39% of companies in the S&P 500 have reported third-quarter results, and the blended earnings growth rate over is tracking to 22%, slightly above expectations at the start of the earnings season.

      Of the companies that have reported so far, 82% have reported a positive earnings-per-share (EPS) surprise, and 62% have reported a positive sales surprise, both above the five-year average. More companies are beating estimates than average, but the magnitude of the beats is smaller than average, and price reaction is mixed. This has caused some investors to worry about the aging bull market in the midst of an almost decade-long economic expansion.

      Looking ahead: Profits, earnings and valuations

      Investors are adapting to higher volatility this year after an incredibly quiet 2017. While the CBOE Market Volatility Index (VIX) has spiked to levels we haven't seen in a few months, it still hasn't reached the levels experienced earlier this year.

      Three-month correlations, as measured by the median correlation of the S&P 500 stocks to the S&P 500 Index, have surpassed 51%, which would indicate indiscriminate selling. That's where the fundamentals come in. This is the busiest week on the Q3 earnings calendar with about 30% of S&P 500 companies reporting, across all 11 sectors.

      For calendar year 2018, analysts are projecting earnings growth of 20% and revenue growth of 8%, higher than expectations just a few months ago.

      Looking out into 2019, earnings and revenue growth projections stand at 10% and 5%, respectively. Much of the decline in projected earnings is due to the anniversary of benefits realized from corporate tax cuts. Unsurprisingly, trade and geopolitical apprehensions, coupled with rising input costs, have fueled the narrative of slower economic growth and prospects of a recession. This has consequently led to a decelerating earnings-growth trajectory.

      Recent price declines have also led to more attractive valuations. The S&P 500's multiple as measured by earnings over the next twelve months is 15.7x, below the five-year average of 16.4x. The multiple on 2019 earnings is sub 15x for the S&P 500, with an earnings yield of 6.5%.

      Interestingly enough, the S&P 500 performance tends to be best when earnings growth is moderate, rather than strong (over 20%), according to Ned Davis Research.

      Blog Image SPX Earnings Table Oct 25

      Additionally, profit margins, as calculated by net income as a percentage of sales, have remained healthy and currently stand above last year's Q3 levels for the market in all but one sector (real estate investment trusts or REITs).

      Margins could see some pressure in 2019 as rising costs associated with higher raw materials, labor, transportation and effects of currency weight on profits. Profit margin declines of 10% or greater have led to recessions in the past, and we do not see any evidence of the decline to this magnitude to date. We believe companies exhibiting structural or secular-driven pricing power levers are among those best-positioned to weather the near-term challenges.

      Bottom line: We believe a healthy dose of skepticism on the market and earnings is appropriate, particularly with so many crosscurrents. While earnings growth is expected to decelerate in 2019, absolute revenue and earnings expectations remain healthy. Every market environment creates winners and losers, and this one is no different. We believe volatility will remain elevated and as such, active selection and diversification may offer the best defense for investors.