Earnings Growth Supports Strong Equity Market Advance

Fourth quarter 2020 earnings reports are nearing an end as 495 companies in the S&P 500 Index have reported results. Refinitiv's report dated March 5, 2020 notes results have come in better than history. Nearly 80% of companies have reported earnings above analyst estimates, exceeding the long-term average of 65%. Expectations for the next two quarters shows earnings growth accelerating with the second quarter 2021 estimate currently indicating growth of 51.2% on a year over year basis.

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Earnings Matter And They Have Improved Significantly

This week the government released the second estimate of third quarter U.S. GDP at 33.1% growth at an annual rate, unchanged from the earlier advanced estimate. This is a sharp snapback from second quarter's 31.4% contraction. Of course this significant swing is a result of the virus mandated economic shutdown and reopening.

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Earnings Support Market's Recent Move Higher

The one thing investor know about company earnings reports is it is a rearview mirror look on what has occurred on a quarterly or annual basis. This backward view may add little insight into what expectations might unfold in the future. Over the long run though, stocks do tend to follow earnings and or cash flow. Having noted this, the S&P 500 index bottomed in March while earnings bottomed in the second quarter, thus, the market seemingly anticipated an improved earnings environment. Subsequent to the market's March bottom, the S&P 500 Index has moved higher on a nearly uninterrupted path as seen in the below chart.

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The Stock Market And Economy Seem To Be In Sync

There are times when I write a blog article and I remind readers the stock market and the economy are not the same. By that, I mean the stock market sometimes moves counter to what one might expect based on economic data releases. Often times this divergence occurs as the stock market is forward looking and its movement anticipates better or worsening economic conditions while much of the economic data is reporting on the past. Today however, it seems the market and economy are in sync to a certain degree. Since the S&P 500 Index low on March 23 it has returned over 53% on a price only basis as of the this past Friday. Over the last 24 weeks, the S&P 500 Index has generated a positive return in 16 of them with 8 weeks being down. Following is a review of some economic highlights which suggest many areas of the economy are improving in a 'V-shaped' manner.

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Stock Prices Reflecting A Resumption In Earnings Growth

One factor about the equity market is its movements are often influenced by expectations. Economic news that is reported better than those expectations can impact broad equity market prices and earnings that beat expectations are an important variable impacting the price of stocks too. For the broader marker, in this case the S&P 500 Index, earnings expectations for 2021 appear to have bottomed as the hook at the end of the red line on the below chart shows. Also important is earnings growth is expected to resume with an increase of 26% in 2021 versus 2020 and a further 16% increase for 2022 versus 2021.

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Downside Earnings Revisions Tend To Peak Near Market Bottoms

It is not surprising company earnings revisions have been mostly downside revisions with most of the country/consumers sitting at home. What is noteworthy though is the upside to downside earnings revision ratio tends to bottom near equity market bottoms. During the 2008/2009 financial crisis, the revision ratio bottomed in late February and the S&P 500 Index bottomed a little over two months later. As the below chart shows, the current upside/downside ratio is lower than the ratio reached at the bottom of the financial crisis in 2008/2009.

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"Buy The Dip" Supported By Economic And Earnings Data

On Friday, January 31, the S&P 500 Index fell 1.77% resulting in the year to date return for the month of January equaling a negative .16%. That Friday decline meant the Index's return was down 3.22% from the year's high. One common phrase that describes investor behavior of late is "buy the dip." Last week's market action, up four days in a row until Friday's decline, is evidence that this "buy the dip" mentality remains a characteristic of the current bull market.

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Stocks Responding To Improved Earnings Expectations

Earnings growth expectations for S&P 500 companies continue to improve with the 12-month forward earnings growth estimate equaling 9.18%. This improving trend has been in place since February and is one tailwind supporting higher stock prices so far this year.

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Improvement In Forward Earnings Expectations Versus Trailing Actual

Just as the market encountered an earnings recession in 2015/2016 due in part to the after effects of higher oil prices and a stronger US Dollar, current earnings reports show S&P 500 earnings growing at a low single digit pace. A large part of today's earnings slowdown is attributable to the tougher prior period comparisons resulting from the earnings improvement from the tax cut in late 2017. I wrote a post earlier this year on this topic and will not repeat it here, but those interested can read it at this link, The Tax Cut And Jobs Act Is Distorting 2019 Estimated Earnings Growth.

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Economic And Company Data More Positive, But Headwinds Exist

One area of the economy in both the U.S. and abroad that has garnered heightened attention of late is the manufacturing sector. Based on business surveys it is clear trade and tariff issues are having a more significant impact on the manufacturing sector. As the below chart shows the Purchasing Managers Index for manufacturing has dipped below 50 in the Eurozone yet remains above 50 in the U.S. A reading below 50 indicates the manufacturing sector is contracting, but not necessarily a recessionary level reading. Recessionary readings generally are in the low 40's area. Although the U.S. manufacturing PMI is above 50, the sector has slowed since its mid 2018 level.

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Earnings Growth Expected To Increase From Here

Second quarter earning season kicks into gear in the coming week and a lower bar seems set by a number of firms. Downward estimate revisions are occurring in twice the number as upward estimate revisions. As it stand now, second quarter earnings are estimated to be lower than the same quarter last year by 1.9%, yet I expect earnings growth in the quarter to be positive when the reporting season comes to a close.

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The Tax Cut And Jobs Act Is Distorting 2019 Estimated Earnings Growth

With first quarter earnings season shifting into high gear (50 companies reporting the week of April 15), investors will contend with a slower pace of earnings growth in 2019 versus 2018. The difficulty is the fact 2018 earnings saw a significantly higher pace of growth due to the passage of the Tax Cuts and Jobs Act (TCJA) that lowered the corporate tax rate; thus, providing an earnings tailwind for companies. Analyst accounted for this tax cut benefit by revising company earnings higher as 2018 unfolded.

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Trend In Index Earnings More Important Then A Slowing Rate Of Earnings Growth

One issue strategists are highlighting of late is the fact the earnings growth rate for the S&P 500 Index in 2019 is expected to decelerate from the mid to high 20+% level this year to the mid single digit percentage level in 2019. Some have indicated this slowing earnings growth rate may negatively impact U.S. equity returns next year. Of course the strong rate of earnings growth this year is due in part to the benefit companies have received from the tax cut. In addition to the tax cut benefit though, companies are seeing top line revenue growth in the high single digit percentage level. Although earnings will remain at a higher level due to the lower tax rate, the year over year growth rate in earnings will fall back to a more normalized level next year as the earlier year comparison is a higher number.

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If Earnings Matter, Equity Valuation Looks Attractive

With last week's final reading on first quarter GDP, the Bureau of Economic Analysis provides a final review of the National Income and Product Accounts (NIPA). One category worth evaluating is the corporate profits figures. Corporate profits from the NIPA tables are true economic profits from IRS data and not simply profits based on GAAP. In the final GDP report last week, corporate profits with IVA & CCAdj totaled $1.92 trillion at a seasonally adjusted annual rate versus $1.64 trillion in the same period a year earlier. This represents a nearly 17% increase in profits from a year earlier.

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