Earnings are expected to improve dramatically. Which isn’t always great for stocks.
The stock market’s tough September continued on Monday.
All three major indices fell to start the week with the S&P 500 declining for its fourth-straight day, its longest losing streak since February.
And so after the market enjoyed its best August in decades and the rally off of the March lows seemed unstoppable, bulls are now facing the biggest test since the spring. And the upcoming earnings season poses a huge challenge to the market’s current narrative.
In a note to clients on Monday, Nick Colas, co-founder at DataTrek Research, flagged the following chart from FactSet, which shows how investors expect corporate earnings to evolve in the coming year.
By the fourth quarter, earnings are expected to exceed the first quarter hit and by the third quarter of next year corporate earnings should exceed pre-COVID levels. A more positive outlook for earnings in the coming quarters has certainly bolstered the markets in recent months.
“We’re not big fans of saying ‘this is the only chart that matters to stocks,’” Colas writes, “but the...graphic from FactSet, which shows analysts’ estimates for the next 5 quarters as compared to the last 7, comes pretty close to meeting that hyperbolic moniker.”
Colas adds that the third quarter will serve as “the first recovery quarter from the COVID Crisis and it needs to beat expectations solidly (just like Q2). Our assumption is that markets will rally into the start of earnings season because investors know we’re ultimately in the early part of an earnings recovery and that’s when we have the best chance of upside surprises.”
In the second quarter, for instance, earnings were far better than feared and companies offered above-consensus guidance at a record pace. The market’s rally in the spring and early summer was underpinned by expectations that corporate results would indeed not be as bad as indicated by the market’s sharp decline in the spring.
The market’s recent stumble, however, suggests investors aren’t quite as positive about the upcoming earnings season delivering to the same extent. And a series of earnings beats and positive investor reaction to that news could be needed for investors who have now seen markets weaken as strategists across Wall Street wonder if we’re at a peak fiscal support, peak Fed support, and perhaps a peak in the market’s initial recovery.
And Colas’ outline that third quarter earnings season must indicate that we’re early in the earnings recovery is the key point. Because market history shows that when earnings growth is realized — rather than anticipated — markets often receive the news with limited enthusiasm. It is always what will happen that matters more for investors than what is happening.
A simple but essential point investors must always keep in mind when trying to make sense of the what and why of any market trend.
Back in 2018, we highlighted work from strategists over at Bank of America Global Research which made this exact point and which we frequently keep in mind here at The Morning Brief.
“Over the past 90 years, the market has ended the year in negative territory 29 times,” Bank of America wrote at the time. “Of those 29 times, [earnings per share] was up almost 70% of the time and up double-digits close to 50% of the time.
“Over that same period, the correlation between annual S&P 500 performance and GAAP EPS is only 18%. If you lag EPS by one year, the correlation improves a bit to 42%, but even then, the corresponding r-squared implies that less than 20% of the S&P 500‘s annual performance is driven by earnings growth. We think that sentiment and growth expectations are a bigger driver of near-term returns, particularly late in bull markets.”
And right on cue, the S&P 500 in 2018 endured its worst year since the financial crisis while corporate earnings grew by 20% due to the benefits of tax reform.
Actual earnings growth is far less important for markets than anticipated earnings growth. It is what the future implies that sends stocks higher, not what the present delivers.
A popular narrative in the spring and summer said that stocks were “disconnected” from the real economy. Which is just not true — stocks were anticipating a stronger-than-expected economic and corporate outlook for later in 2020 and into next year. In the second quarter, these results materialized.
But this same logic applies on the downside as well. And third quarter earnings merely meeting elevated expectations isn’t likely to be a winning formula for the bulls. At least not if history is any guide.
This article originally appeared on Yahoo! Finance.
