Q3 earnings have crushed estimates … why it shouldn’t have surprised anyone … what forward earnings estimates tell us about market direction
The Wall Street sandbagging operation worked like a charm …
To explain, let’s rewind to a Digest from just over a month ago:
Q3 earnings season kicks off today, and stocks are likely headed higher.
The reason behind it?
Positive earnings surprises.
Now, at first glance, this seems like a tall order.
FactSet, which is the go-to data analytics company the pros use for earnings estimates, is estimating a year-over-year earnings-decline for the S&P of -20.5%.
If that happens, it will be the second largest year-over-year decline in earnings ever — behind only 2009.
So, where’s the optimism coming from?
Well, in short, Wall Street is incentivized to sandbag earnings.
In that Digest, we detailed how analysts intentionally set low earnings hurdles. This makes it easy for positive earnings surprises, which propels the market forward in the short-term.
The crazy thing is that Wall Street knows it’s happening, yet it continues to work, quarter-after-quarter.
Below is a chart from FactSet that shows earnings estimates in gray, alongside real earnings in blue, dating back to Q4 2017.
What you’re going to find is that over a span of 11 quarters, estimates came in below actual results 10 times.
And what about the lone instance in which actual earnings were worse than estimates?
That was Q1 of this year, when the pandemic took the world by surprise, which analysts obviously didn’t see coming.
***As I write Wednesday morning, we’re wrapping up Q3 earnings season
According to FactSet, more than 92% of the companies in the S&P 500 have reported.
So, how have actual earnings come in relative to the earnings collapse that was predicted?
… 84% of S&P 500 companies have reported a positive EPS surprise and 78% have reported a positive revenue surprise.
If 84% is the final percentage, it will tie the mark for the highest percentage of S&P 500 companies reporting a positive EPS surprise since FactSet began tracking this metric in 2008 …
As of today, the S&P 500 is reporting a year-over year decline in earnings of -7.1%, compared to a year-over-year decline in earnings of -21.2% at the end of the third quarter.
That’s absurd — analysts predicted an earnings-decline of -21.2% but they came in at just -7.1%.
Kudos to the overestimation of 200%.
The sandbagging operation is alive and well.
***Despite the sandbagging, what do forward earnings estimates suggest about stock-market direction?
So, Q3 earnings were strong.
Wonderful, but the real question for investors is always “what’s next?”
To help answer that, we can look at forward earnings estimates, and compare them to how expensive the market is today.
This is called the forward PE — it answers the question “how much am I paying today in exchange for what earnings are projected to be in 12 months?”
Right now, FactSet reports that the forward 12-month PE ratio for the S&P 500 is 21.6.
The bad news is that this is high.
For context, the average 5-year forward PE is 17.3. So, we’re 25% more expensive than this average.
Now, on one hand, markets can remain out of balance for a long time. You’ve probably heard the famous John Maynard Keynes quote: “The markets can remain irrational longer than you can remain solvent.”
On the other hand, with enough time, markets revert to their averages.
So, if today’s forward PE is well-above average, and is going to revert back to its longer-term average, then one of two things will need to happen in the ensuing quarters …
One, earnings will enjoy real growth.
This will take pressure of today’s lofty forward-PE number because it makes an expensive market less expensive. After all, investors are getting more earnings bang for their buck.
Two, stock prices will fall.
This would happen when investors come to the unfortunate conclusion that the true shape of earnings is worse than expected, and doesn’t support expensive stock market prices.
This would also take pressure of an inflated forward-PE number, but in the way that investors don’t want — by their portfolio-values taking a hit.
So, which one is going to win out here?
Well, we’d suggest there’s actually a third option that falls in-line with the Keynes quote …
***Forward PEs will remain around their current, elevated levels because both earnings and market prices are going to keep climbing
So, we have two variables — the price of the stock market, and the size of earnings. If they both rise in relative proportion, then the valuation multiple would remain the same.
What’s the case for this possibility?
Well, let’s start with why the price of the market is headed higher.
One, we made it through the potential drama of the presidential election unscathed. At present, it appears we’ll have gridlock in the government, which decreases the odds of significant reform legislation that curbs Wall Street in a meaningful way. Basically, get ready for more of the same.
Two, we have a 0%-interest-rate environment along with the Fed pledging to do whatever it takes to prop up the economy. Federal Reserve Chairman Jerome Powell has an itchy stimulus finger — and history has shown how a quick shot of trillions of dollars can goose a stock market.
And three, we now have highly effective vaccines on the horizon. This has Wall Street focused on what an unshackled economy later this spring/summer will mean for earnings.
So, despite what could be a tough winter with COVID-19, “normal” is out on the horizon.
Put all of this together, and it’s resulting in one thing …
Investors are being lured into the market from the sidelines. From CNBC:
Money is pouring into stocks through exchange-traded funds …
Money is pouring in because U.S. investors who have been reluctant to put money into equities are now stampeding into stocks on the belief that that the “Covid winter” of 2020 will be followed by the “Reopening spring” of 2021, and many are choosing ETFs as that investment vehicle.
As proof of this, the U.S. ETF industry just surpassed $5 trillion in assets under management — that’s a new record.
Now, yes, record-highs for stocks is partially responsible, but over $400 billion in new money has poured into ETFs this year.
For context, ETF inflows stood at just $246.6 billion at this same point last year.
Add to this, just two weeks ago, we saw the largest week ever in global stock inflows.
You can see this below from Bank of America Global Investment Strategy:
Bottom-line — a new wave of capital is beginning to flood the stock market. This is pushing the market higher
***Now, what about higher earnings?
Well, let’s return to FactSet:
For Q4 2020, analysts are projecting an earnings-decline of -10.8% and a revenue decline of -0.2% …
For Q1 2021, analysts are projecting earnings growth of 14.5% and revenue growth of 3.3%.
For Q2 2021, analysts are projecting earnings growth of 43.9% and revenue growth of 13.6%.
For CY 2021, analysts are projecting earnings growth of 22.1% and revenue growth of 7.8%.
In short, after Q4, we’re looking at a tremendous amount of earnings growth.
Below, you can see next year’s earnings estimates coming in at record levels, topping 2019’s numbers.
Plus, keep in mind Wall Street’s little sandbagging game …
Since analysts nearly always underestimate, even these projections are likely tame.
***You should be long stocks now
Yes, it’s an expensive stock market on a forward-PE basis.
But as Keynes pointed out, that doesn’t mean things have to change anytime soon.
If we look at facts, money is flowing into stocks. And as the vaccine is distributed throughout our nation and world, you can expect investors to continue pouring money into stocks.
Meanwhile, also looking at facts, we have soaring earnings estimates. And as the COVID-19 vaccines help our economy reopen, those estimates could easily prove too low.
So, don’t expect the stock market to get “cheaper,” but do expect it to drive your portfolio higher.
Have a good evening,