Corporate earnings continue to beat expectations – like usual … how this game works … what forward-earnings estimates are telling us … what to expect from the market
Another earnings season, another series of positive earnings “surprises” that really shouldn’t surprise.
Here’s where many headlines were a few weeks ago, before Q1 earnings season started…
Here’s how the press began changing its tune a few days into earnings season…
And here’s where we are today…
It seems like every earnings season, investors are subjected to dire warnings of earnings disappointments. Yet just about every time, the numbers come in better than expected.
How?
And why?
It’s simple really…
Wall Street is incentivized to sandbag earnings.
Especially in an uncertain economic environment like we have right now.
Our technical analysts and the team behind Strategic Trader, John Jagerson and Wade Hansen, explained this phenomenon last year, and it’s no less applicable today.
Here they are explaining the song-and-dance:
It’s simple. You lower earnings expectations and then watch corporate America beat those lowered expectations.
You see, Wall Street analysts are professional sandbaggers.
Buy-side analysts — those that work for firms that buy stocks or recommend buying stocks — are amazing at underestimating the true strength of a company’s revenue and earnings potential.
Sell-side analysts — those that work for firms that issue, or sell, stocks — are amazing at finding and emphasizing any little good piece of news about a company and its revenue and earnings potential.
***Why would analysts intentionally sandbag the numbers?
John and Wade tell us the answer boils down to incentives.
Analysts get paid to provide information. If the information they provide makes their clients happy, they continue to get paid. If that information makes their clients unhappy, watch out.
Buy-side analysts know that clients who pay for their insights are going to be much more forgiving of a recommendation that overperforms an earnings-estimate than they would be an estimate that sets up a disappointment, resulting in to a price selloff.
Back to John and Wade:
Quarter after quarter, analysts lower expectations on Wall Street by cutting their estimates in the run-up to earnings season, setting everyone up to be pleasantly surprised when the numbers come in “better than expected.” After all, it’s much easier to clear a lowered hurdle.
The amazing thing is that everybody knows this is happening, yet it continues to work a surprising amount of the time.
***So, how are the earnings numbers shaking out this time?
The below comes from FactSet, which is the go-to data analytics company for earnings estimates (emphasis added):
Overall, 60% of the companies in the S&P 500 have reported actual results for Q1 2021 to date (as of last Friday).
Of these companies, 86% have reported actual EPS above estimates, which is above the 5-year average of 74%.
If 86% is the final percentage for the quarter, it will mark the highest percentage of S&P 500 companies reporting a positive EPS surprise since FactSet began tracking this metric in 2008.
In aggregate, companies are reporting earnings that are 22.8% above the estimates, which is also above the 5-year average of 6.9%.
If 22.8% is the final percentage for the quarter, it will mark the second-highest earnings surprise percentage reported by the index since FactSet began tracking this metric in 2008.
That’s crazy – a full 86% of companies have reported positive earnings surprises as of last Friday. And don’t make the mistake of thinking this is a one-time thing.
Below is a chart we presented in the Digest last fall, also from FactSet. It shows earnings estimates in gray, alongside how real earnings turned out in blue. It dates back to Q4 2017.
What you’re going to see is that over a span of 11 quarters, estimates came in beneath actual results 10 times.
And what about the lone instance in which earnings were worse than estimates?
That was Q1 of last year, when the pandemic took the world by surprise, which analysts obviously didn’t see coming.
Given this sandbagging history, should there be any surprise that we’re experiencing another positive-surprise earnings season today?
***Despite the sandbagging, what do forward earnings estimates suggest about stock-market direction?
So, Q1 earnings are shaping up to be 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 P/E” (forward price-to-earnings ratio) – 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 P/E ratio for the S&P 500 is 22.
That’s high – not egregiously, massive-bubble high, but it’s lofty.
For context, the average 5-year forward P/E is 17.9. So, we’re 23% 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 P/E 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-P/E 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 if investors come to the unfortunate conclusion that the true shape of earnings is worse than expected, and doesn’t support today’s stock market prices.
This also would take pressure of an inflated forward-P/E 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?
Well, we’d suggest there’s actually a third option that falls in-line with the Keynes quote…
Forward P/Es will remain around their current, elevated levels because both earnings and market prices are going to keep climbing.
***The same…but different
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, our nation is reopening after COVID-19. Sure, the speed isn’t uniform across states, but it’s happening – that’s undeniable. It’s creating a buoyant spirit and an expectation of earnings growth as the economy emerges. That’s luring more investors into the market.
Two, many Americans are flush with stimulus cash…and it’s making its way into the stock market.
From MarketWatch in late March:
BofA Global Research on Friday said U.S. equity inflows hit a weekly record of $56.76 billion in the week ending March 17, up sharply from $16.83 billion a week earlier…
Meanwhile, Goldman Sachs estimated that net flows into global equity funds hit a nominal record of $68 billion in the week ended March 17, which when scaled to the level of mutual-fund equity assets was the largest since December 2014.
The rise was largely due to bigger net inflows into the U.S. market, which coincided with the initial distribution of stimulus checks of up to $1,400 for qualified U.S. citizens as part of the $1.9 trillion COVID-19 relief package signed into law by President Joe Biden earlier this month, said analysts at Goldman Sachs, in a Friday note.
Three, as inflation continues to rise, keeping money in cash is increasingly dangerous. Investors will likely pour even more dollars into the market in search of a meaningful return that outpaces inflation.
Turning our attention to earnings, what’s the case for growth in the quarters to come?
Back to FactSet:
For Q2 2021, analysts are projecting earnings growth of 58.3% and revenue growth of 18.1%.
For Q3 2021, analysts are projecting earnings growth of 21.7% and revenue growth of 11.2%.
For Q4 2021, analysts are projecting earnings growth of 16.7% and revenue growth of 8.2%.
For CY 2021, analysts are projecting earnings growth of 31.7% and revenue growth of 10.9%.
Put this together, and we have a climbing market and rising earnings…if these projections play out, it will mean that the forward P/E multiple stays roughly the same.
By the way, if you’re skeptical, I’ll share something you might find interesting…
Last July – nearly a year ago – a Digest issue looked at earnings and came to a similar conclusion that just because the forward P/E ratio was high, it didn’t mean the market was doomed.
And what was the S&P’s forward price-to-earnings ratio then?
22…the exact same level as today.
From our July 14, 2020 Digest:
FactSet (the go-to data-analytics company for earnings numbers) reports that the forward 12-month P/E ratio for the S&P 500 is 22.0…
For context, it’s 30% higher than the 5-year average of 16.9. And it’s 45% higher than the 10-year average at 15.2.
Now, this doesn’t mean we’re going to see a market crash.
Not only didn’t we see a market crash, the S&P has climbed 31% since then, as you can see below.
And again, this happened even though the forward price-to-earnings ratio was the exact same back then as it is today.
That’s what happens when both stock prices and earnings rise.
Though this loose balance could change in the coming quarters, we’re hard-pressed to come up with a strong case for why that would be (that’s not to be confused with volatility, which investors should expect).
***Bringing it all together
Yes, earnings have topped expectations…again.
And yes, it’s an expensive stock market on a forward-PE basis…again.
But as Keynes pointed out, that doesn’t mean things have to change anytime soon.
If we look at facts, investor capital is flowing into stocks. And consumer dollars are flowing into cash registers.
So, don’t expect the stock market to get “cheaper,” but do expect the market to keep grinding higher despite volatility.
Have a good evening,
Jeff Remsburg
