Pump it Up: Earnings Season Starts Off Strong
With less than 10% of the S&P 500 having reported, results are strong and have boosted the blended consensus for first quarter year-over-year earnings growth from 25% to nearly 31%.
Both the beat rate, and the percent by which companies have been beating estimates, are well above historical norms.
The denominator effect of improving earnings (E) is helping ease some valuation concerns; but overall, the market remains historically expensive.
Although it’s early in the first quarter earnings reporting season, it’s worth a look at the progress so far and the implications for the rest of the season, as well as valuations. Less than 10% of S&P 500 companies have reported; but to sum it up, so far so very good. Based on Refinitiv data, the year-over-year “blended” earnings growth estimate (combining actual reports to date with consensus estimates) has jumped to nearly 31%. If it remains at that level, it would be the highest quarterly growth rate since the fourth quarter of 2010.
In aggregate, companies have reported earnings 30.8% above expectations; compared to a long-term (since 1994) average of 3.5% above estimates and average of 15.2% for the past four quarters. The percent of companies reporting better-than-expected earnings (“beat rate”) is 85%; with only 13% having reported weaker-than-expected earnings (“miss rate”). That compares to an average beat rate of 65% and miss rate of 20% since 1994; and an average beat rate of 78% and miss rate of 19% over the past four quarters.
The table below highlights the blended earnings growth rates for the S&P 500 overall; as well as each of the 11 sectors. Prior to reporting season getting underway, the first quarter growth estimate for the S&P 500 was 25%; which as noted has already jumped to nearly 31% thanks to the strength of the season so far. Topping the rankings in terms of growth rate for the quarter is the Financials sector—with a whopping 116% growth expected—followed by Consumer Discretionary. Looking ahead to next quarter, we can see that the traditionally most-cyclical sectors—notably Industrials and Energy—join Consumer Discretionary with eye-popping growth rates of more than 500% in the case of Industrials; and more than 200% in the case of Consumer Discretionary and Energy. These exceptionally strong gains are courtesy of “base effects” and the math associated with year-over-year comparisons relative to the second quarter of 2020; when much of the global economy was in lock-down.
Source: Charles Schwab, I/B/E/S data from Refinitiv, as of 4/19/2021. Forecasts contained herein are for illustrative purposes only, may be based upon proprietary research and are developed through analysis of historical public data. Past performance is no guarantee of future results.
You can see the trajectory of earnings back to 2015 in the chart below. After a four quarter “earnings recession” from mid-2015 to mid-2016 driven by a collapse in oil prices and its impact on the Energy sector, earnings rebounded sharply. Although the overall U.S. economy did not roll into its COVID recession until February 2020; as you can see, S&P 500 earnings actually peaked well before that in 2018’s third quarter. The dotted bars show the aforementioned acceleration unfolding this quarter.
Earnings Growth Set to Ramp
Source: Charles Schwab, I/B/E/S data from Refinitiv, as of 4/19/2021. Forecasts contained herein are for illustrative purposes only, may be based upon proprietary research and are developed through analysis of historical public data.
As mentioned, coming into first quarter earnings season, estimates were for 25% S&P 500 growth; but estimate revisions have been decidedly on the upside. The table below shows the roster of revisions underway since mid-March. In general, there has been an upward trend in the percentage of upward revisions vs. downward revisions; with the latest ratio at two-thirds up and one-third down. The bar chart below the table breaks down the S&P 500 by sector, with the blue bars representing upward revisions, and the orange bars representing downward revisions. In keeping with the lofty growth expectations of the Financial sector, it is dominated by upward revisions—although just shy of the Technology’s best ratio of up-to-down revisions.
Source: Charles Schwab, I/B/E/S data from Refinitiv, as of 4/16/2021.
Tech and Financials on Top re: Revisions
Source: Charles Schwab, I/B/E/S data from Refinitiv, as of 4/16/2021.
What does this mean for valuations?
Last year was defined by a surge in multiples thanks to the strength in stock prices alongside the plunge in earnings. Although last year’s pandemic-related decline in the denominator (E) was epic relative to history, what is in keeping with history is the tendency for multiples to rise in the first year of a recovery as stocks price in the coming improvement to earnings.
As shown below, toward the end of last year, the forward P/E for the S&P 500 had surged to 27. Given that was directly in line with multiples in the late-1990s into the March 2000 market peak; valuation concerns were rampant as we entered 2021. However, unlike the late-1990s—when earnings were rising toward a peak—the surge in the P/E recently was driven by the plunge in earnings. Recently though, thanks to the epic surge in earnings coming from the lows of last year, the forward P/E quickly reset to 22 (before bouncing to 23). That is by no means cheap; but highlights the power of the denominator in the current environment—distinctly different than what occurred in 2000. As you can also see, assuming no change in the price of the S&P 500 (I know, unlikely), the expected progression of earnings would bring with it a further decline in the forward P/E to less than 20.
Thank You E
Source: Charles Schwab, Bloomberg, as of 4/16/2021. For illustrative purposes only.
Regardless of whether the forward P/E is cheap, expensive or something in between; it’s always important to remind investors that valuation is not an effective market timing tool. Markets can become expensive and stay expensive for some time, without a deleterious impact on stock prices—especially when investor sentiment and momentum are dominant drivers, as is the case today. As shown in the scattergram below; although there is a negative correlation between the forward P/E and subsequent one-year S&P 500 performance (i.e., higher P/Es have been followed by weaker stock market returns), it’s a very slight negative. In fact, even with a quick glance at the scattergram, you can see that the “exceptions” to the yellow correlation trend line are far and wide.
Don’t Use P/Es to Time Market
Source: Charles Schwab, Bloomberg, 1958-3/31/2021. Correlation is a statistical measure of how two investments have historically moved in relation to each other, and ranges from -1 to +1. A correlation of 1 indicates a perfect positive correlation, while a correlation of -1 indicates a perfect negative correlation. A correlation of zero means the assets are not correlated. Past performance is no guarantee of future results.
Forward P/Es are, of course, among many valuation metrics that investors tend to track. In the “heat map” below, you can see that although the forward P/E has retreated, it remains well in the red zone in terms of historical percentiles. Most other P/E valuation metrics are also well into the red zone; as well as price/book, Tobin’s Q (market value/assets’ replacement cost), and market cap/GDP (“Buffett Model”). Still in the green, however, are the yield-based valuation metrics of equity risk premiums and the Fed Model.
Source: Charles Schwab, Bloomberg, The Leuthold Group. Forward P/E, price/book, price/cash flow, rule of 20 and equity risk premiums as of 1990-4/16/2021. Trailing and normalized P/E as of 1960-4/16/2021. Dividend yield as of 1928-4/16/2021. CAPE as of 1900-4/16/2021. Fed model as of 1965-/4/16/2021. Tobin's Q as 1950-4/16/2021. Market cap/GDP as of 1952-4/16/2021. Percentile ranking is shown from lowest in green to highest in red. A higher percentage indicates a higher rank/valuation relative to history.
The surge in earnings is providing a fundamental factor for bulls to cheer; while also serving as a catalyst for some easing in valuation concerns. As we saw earlier this year though, any acceleration in Treasury yields could put renewed pressure on higher-multiple segments of the stock market. In addition, as shown above, earnings growth is likely to peak in the second quarter; which is likely to correspond to the peak in the annualized quarter-over-quarter growth rate in real gross domestic product (GDP).
Rich valuations coupled with stretched investor sentiment conditions suggest risk is high for a pullback or correction, and spikes in volatility. For now, market breadth remains healthy (more so for the S&P 500 than the NASDAQ or Russell 2000)—which has historically been a positive offset to stretched valuations/sentiment. This is a market environment that has started to reward strong fundamentals again, after a period dominated by lower-quality factors earlier this year. In fact, profitability was the leading performance factor last week, while accelerating sales is the best performing factor over the past month. A fundamentals-driven market is easier to navigate than a speculative low quality factors-driven market. Nonetheless, discipline around risk mitigation is essential; including diversification across and within asset classes, and periodic rebalancing.
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Shiller’s Cyclically-Adjusted P/E (CAPE) - This model uses an inflation-adjusted price for the S&P 500 and divides by reported earnings over the prior 10 years.
Rule of 20: Stocks are considered fairly valued when the sum of the S&P 500 forward P/E ratio and the year-over-year change in the consumer price index (CPI) is equal to 20 (or inexpensive when it's below 20).
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