Wall Street banks are bullish on earnings season -- but for different reasons

Banks across Wall Street can agree on at least one thing right now: that the upcoming earnings season will lead to strong results in the stock market.

But the big banks disagree about the reasons for that strength.

Let’s start with Goldman Sachs, which predicts that bullish expectations around corporate tax reform will provide a backstop for equity appreciation. And the market may just need an external catalyst, since the firm expects S&P 500 earnings to grow only 5% this quarter, down from the double-digit expansion seen in the first two quarters of the year.

The impact of the catastrophic hurricane activity that hit the US during the reporting period will also give investors a higher tolerance for a profit growth slowdown, which could be viewed as temporary, Goldman said.

“We expect investors will ignore the EPS slowdown given one-time hurricane effects and the focus on benefits from corporate tax reform,” a group of the firm’s strategists led by David Kostin wrote in a client report, noting that optimism around tax measures was crucial in the S&P 500’s ascent to new records last week.

Morgan Stanley is similarly optimistic — but their stance stems more from what they view as an underpricing of earnings results. While the firm readily admits that this may be a result of companies keeping forecasts low so they can more easily beat them, it also notes that earnings outperformance does tend to drive share gains.

However, Morgan Stanley thinks investors have caught on to this financial engineering technique, and have already started bidding up stocks in anticipation of easy earnings beats.

“Stocks correctly recognised this low bar a few weeks ago and have rallied sharply into earnings season,” strategists led by Michael J. Wilson wrote in a client note. It’s been a “familiar pattern this year.”

The firm also highlights the continued upward trend for S&P 500 12-month forward earnings, as shown in the chart below:

Screen Shot 2017 10 09 at 11.05.09 AMMorgan StanleyS&P 500 full-year estimates have remained stable.

Bank of America Merrill Lynch shares Morgan Stanley’s view that traders have already keyed in on what they see as a better-than-expected earnings season. While the firm says that “a good 3Q is priced in,” it recognises that there could be further gains if companies provide positive forward guidance.

“Corporate optimism based on guidance is near 7-year highs,” BAML strategists led by Savita Subramanian said in a note to clients. “A continuation of these trends may be key to market strength.”

BAML also highlights a weak US dollar as boosting the profitability of multinational corporations, many of which have large weightings in major equity indexes. An index tracking the greenback versus other currencies has fallen 8.3% in 2017.

These types of forecasts are starting to accelerate, with earnings season set to kick off in earnest this week. Financials will get the proceedings going on Thursday, with JPMorgan and Citigroup due to report results. Then Wells Fargo and Bank of America are scheduled to announce earnings on Friday.

So the question now becomes — how do these earnings forecasts translate to year-end expectations on the S&P 500?

Interestingly enough, even though Goldman sees tax reform propping up the benchmark during this reporting period, its 2017 forecast calls for the S&P 500 to fall roughly 6% to 2,400. Meanwhile, BAML sees a more measured drop to 2,450 by the end of 2017.

It must be noted that neither firm thinks that third-quarter earnings season will be responsible for the consolidation into the end of 2017. As outlined above, they’re constructive — if not outright bullish — on the period.

It’s actually Morgan Stanley that’s carrying the bullish flag for the stock market, expecting the gauge to climb to 2,700 by the end of first quarter 2018 — the most bullish target on Wall Street.

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