Has Peak Earnings Growth Meant Peak Stock Market?

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Published August 6, 2021

Below is an article from Schwab on the connection between earnings and the stock market.

“In what shaped up to be a very impressive first half of the year for both the economy and stock market, stellar earnings growth has been a key ingredient. Coming off stronger-than-expected S&P 500 earnings growth of 53% (year over year) in the first quarter, second-quarter earnings are currently anticipated to grow by 78%, the highest since 2009. That is well higher than the initial consensus estimate of 65%.
As was also the case in the first quarter, the beat rate—the percentage of companies reporting earnings growth higher than analysts’ estimates—remains quite high at 89%. In a typical quarter (since 1994), 66% of companies beat estimates; and over the past four quarters, the beat rate has been 83%. So, the current quarter’s beat rate is shaping up to be in line with the past year.

In the table below, you can see a sector breakdown for growth this quarter (and into the next full year). Cyclical areas of the market sit atop the earnings leaderboard, including Industrials, Consumer Discretionary, and Energy. Much of that is due to their tighter connection to economic growth; but also “base effects” given their marked struggles in last year’s second quarter, when the economy was shut down.

Earnings strength led by cyclicals

Earnings strength led by cyclicals
Source: Charles Schwab, I/B/E/S data from Refinitiv, as of 7/26/2021. Forecasts contained herein are for illustrative purposes only, may be based upon proprietary research and are developed through analysis of historical public data.

As shown above, the second quarter is expected to represent the peak in the earnings growth rate (although not in the overall level of $ earnings). As of now, the growth rate is expected to slow to 27% in the third quarter, a noticeable decrease but still strong. Future estimates show a consistent stairstep pattern down, as shown in the chart below.

As earnings cool, so does market historically

As earnings cool, so does market historically
Source: Charles Schwab, I/B/E/S data from Refinitiv, as of 7/26/2021. 4Q08’s reading of -67% is truncated at -40% and 4Q09’s reading of 206% is truncated at 80%. Forecasts contained herein are for illustrative purposes only, may be based upon proprietary research and are developed through analysis of historical public data.

Unsurprisingly, the market has tended to move in concert with earnings growth (or lack thereof in instances of economic and/or earnings recessions). As history shows, the deceleration in profit expansion is suggestive of more modest returns for the stock market. Yet, that doesn’t mean we’re facing an imminent downturn, given we are moving off a peak north of 50% for the S&P 500’s year over year return.

In the near term, the good news is that investors have been rewarding companies that beat analysts’ expectations. The average company has produced a return of +0.3% above the S&P 500 on their earnings day, thus far. That may seem like a given – e.g. earnings beat leads to share outperformance. But as shown in the chart below, it hasn’t been the case in the past couple of quarters. For companies that beat estimates in the first quarter of 2021, their average earnings report day return in excess of the S&P 500’s was a paltry 0.1%; while in the fourth quarter of 2020, it was -0.4%. Less surprising is the fact that companies missing estimates have underperformed the overall market on earnings report day by an average of -2.1%.

Beats again being rewarded

Beats again being rewarded
Source: Charles Schwab, Bloomberg, as of 7/23/2021. Past performance is no guarantee of future results.

Dissecting valuation

The strength in earnings has continued to alleviate some valuation pressures. Coming off the March 2020 lows and through the end of last year, the S&P 500’s forward price/earnings (P/E) ratio soared to its highest since the dot-com bubble in the late-1990s, as earnings (the denominator) fell sharply and stock prices (the numerator) rebounded swiftly. This year, earnings have been on fire, which has helped bring down the forward P/E, as shown in the chart below. The dotted lines show both the expected trajectory for earnings and in turn what the trajectory for the forward P/E would be, all else equal. (The P is not stationary, so the blue dotted line is purely illustrative of the power of a rapidly improving E.)

The ‘E’ still doing the heavy lifting

The ‘E’ still doing the heavy lifting
Source: Charles Schwab, Bloomberg, as of 7/23/2021. Forecasts contained herein are for illustrative purposes only, may be based upon proprietary research and are developed through analysis of historical public data.

Notwithstanding the decline in the forward P/E since late-last year, stocks are not cheap in absolute terms. Most valuation metrics that include price as the numerator are still quite stretched relative to their long-term history, as shown in the chart below. On the other hand, yield- or interest rate-based metrics—such as equity risk premiums—show that the market looks more attractive at current levels; given interest rates remain historically low.

As we often remind investors, although valuation metrics are considered fundamental in nature—given their quantifiable components—the reality is that valuation is also an indicator of sentiment. Just as record-high valuations in the late-1990s were tied to abundant euphoria; the extremely low valuations in early-2009 reflected abundant despair.

Rate-based valuations remain in green zone

Rate-based valuations remain in green zone

Source: Charles Schwab, Bloomberg, The Leuthold Group, as of 7/23/2021. Due to data limitations, start dates for each metric vary and are as follows: CAPE: 1900; Dividend yield: 1928; Normalized P/E: 1946; Market cap/GDP, Tobin’s Q: 1952; Trailing P/E: 1960; Fed Model: 1965; Equity risk premium, forward P/E, price/book, price/cash flow, rule of 20: 1990. Percentile ranking is shown from lowest in green to highest in red. A higher percentage indicates a higher rank/valuation relative to history. For illustrative purposes only.

The one exception to the bullish yield-based argument is the S&P 500’s real earnings yield (REY), which is the inverse of the P/E ratio, adjusted for inflation (consumer price index). Thanks to the recent spike in inflation, the REY has fallen sharply into negative territory. As shown in the chart below, at -2%, it’s at its lowest since 1974. The rub is that, for what was the entirety of the bull rally that preceded the pandemic, this metric was used as a justification for equities that otherwise looked extremely stretched relative to earnings. Clearly that isn’t the case anymore; and for what it’s worth, when the real earnings yield was negative in the past, the average forward one-year return for the S&P 500 was -4.7%.

A real problem for the real earnings yield

A real problem for the real earnings yield

Source: Charles Schwab, Bloomberg, as of 6/30/2021. Real earnings yield is defined as S&P 500 current earnings yield minus y/y % change in CPI. Past performance is no guarantee of future results.

In sum

While earnings have already surprised to the upside in the second quarter, the magnitude of strength has been expected. Looking ahead, earnings growth rates will likely continue to cool, as comparisons to the prior year inevitably become more difficult. As we have continued to point out, investors should focus not just on the earnings growth rate; but also what companies are saying with respect to inflationary pressures, profit margins, and forward guidance.

If supply constraints and some temporary spikes among commodity prices were severe enough to weigh on companies’ pricing power, there is a risk that profit margins take a hit in the near future. For now, forward margin estimates haven’t weakened and companies have raised forward guidance at an impressive rate. This is a welcome improvement relative to last year, when a record number of S&P 500 companies were forced to eliminate guidance (given the unique uncertainty brought on by the pandemic). While there is a considerable portion of S&P 500 members still to report, the upgrades in outlooks thus far are signaling continued strength for profits.

Market behavior could become choppier as earnings growth slows; with continued, large swings in sector leadership (on a day-to-day and week-to-week basis).”

Here at TimingCube , we appreciate the flexibility of our models – their ability to thrive both in environments where earnings growth is high as well as when earnings growth slows and markets dip. This past year has been a perfect example, with our Turbo model producing outsized returns during the market selloff in early 2020 AND during the subsequent rebound.

Market Update

Investors began the week with stocks down -0.2% Monday on little news. Small business payment company, Square, announced a major acquisition, putting a bid under financial stocks. A strong +0.8% advance Tuesday on good earnings reports from retailers Ralph Lauren and Under Armour. A solid report on the economy’s services sector was overwhelmed by a disappointing private sector hiring report leading stocks lower by -0.5% Wednesday. As has been the case all year, investors swooped in to buy the small dip sending indexes back to record highs. The +0.6% Thursday rise came on a tick upward in interest rates. That trend continued Friday with rates surging to 1.3% on the 10-year Treasury note, up from 1.15% just two days earlier. The rise in rates lit a fire under bank stocks to push the S&P 500 higher by +0.2%.

A back and forth week for stocks left the indexes at record highs. The S&P 500 rose +0.91% for the week, matched by the Nasdaq’s +0.95% increase. The strong performance from financial stocks helped smallcap stocks to a +1.06% weekly gain.

Warm wishes and until next week.