Earnings expectations for the second quarter were too low -- maybe by design. And that’s pointing to an economic recovery from the pandemic on track to continue its speedy pace. But indications of forward-looking uncertainty are holding the market back somewhat.
The second quarter is expected to mark the trough in the earnings decline seen on the S&P 500, as massive amounts of monetary and fiscal stimulus have aided businesses and consumers through the wreckage of the past few months. The unemployment rate has fallen from above 15% to around 10% in just a few months and the consumer -- about 70% of U.S. GDP -- is showing signs of life.
Valuations, seemingly inflated by lowered interest rates, are actually nowhere near overstretched by historical standards. This means stocks do have some upside if the virus remains contained and if Congress can deliver more fiscal stimulus, but it also signifies investors are concerned about the future. And if valuations remain where they are, a dimming 2021 earnings outlook will be a clear negative for stocks. Investors, while noticing that earnings-per-share estimates for 2021 indicate an almost V-shaped recovery, are demanding a slight risk premium on stocks as those forecasts are far from rock solid.
The 10-Year Treasury yield, which has been essentially stuck at 0.7% since early April, may remain depressed for some time. Bond fund managers TheStreet has spoken with have all said they expect rates to remain low as long as pronounced uncertainty remains a theme. That’s supporting stocks but indicates uncertainty. Credit spreads -- the difference in yield on riskier bonds over that of the safe 10-Year Treasury bond -- are still above 5%, historically wide. "I don’t see spreads tightening,” Jay Sommariva, director of fixed income at Fort Pitt Capital Group told TheStreet. “We’ve had a lot of compression in the last 6 to 8 months. People want to be paid to take some extra risk and you might see some widening.”
The equity risk premium on the S&P 500, the earnings yield for the next 12 months for the average stock on the index minus the yield on the 10-Year Treasury bond, is at around 3.7%, compared to historical averages of around 3.4%. So the “spread” on stocks is wide, too. And it’s important to note there has been a higher risk premium demanded in value stocks compared to growth stocks, signifying more bearishness on the economy.
According to most investors, the market is likely to let this risk premium sit where it is for some time as earnings and economic data roll in.
But since June 26, the S&P 500 is up 12%, with massive outperformance from large cap growth tech stocks like Apple (AAPL) - Get Apple Inc. (AAPL) Report, Amazon (AMZN) - Get Amazon.com, Inc. Report, Facebook (FB) - Get Facebook, Inc. Class A Report and Microsoft (MSFT) - Get Microsoft Corporation (MSFT) Report, which all put earnings estimates to shame. The FAANG group plus Microsoft accounts for almost 25% of the S&P 500’s market cap, so without those stocks, the S&P 500 would look a bit less optimistic on the future. Still, The Vanguard S&P 500 Value etf (VOOV) - Get Vanguard S&P 500 Value ETF Report, home to large cap defensive and cyclical names, is up almost 11% since June 26 as earnings have been strong across sectors.
Unsurprisingly, 83% of S&P 500 companies are beating earnings estimates and almost all companies have reported, according to data from FactSet. That would mark the highest percentage of beats on the index since FactSet started tracking earnings in 2008. And companies are beating estimates by an average 23%, which FactSet notes is well above the 5-year trailing average. Earnings growth has been negative 33%, against initial analyst estimates of negative 45%.
More than 64% of companies are beating on revenue, suggesting some companies are showing strong operating leverage and keeping costs at bay.
And in cyclical sectors, or those sensitive to changes in the economy, industrials are performing particularly well. About 80% of large cap industrials have beaten estimates, according to data from Morgan Stanley equity strategists, with 83% of capital goods companies beating. The Equal-Weight S&P 500 Industrials Index is up 18% since June 18 and Caterpillar (CAT) - Get Caterpillar Inc. Report is up almost 15%.
Most consumer discretionary companies are beating -- about 62% -- but notable strength is also found in financials, with about 70% beating exceptions. Still, banks have underperformed.
Large cap banks kicked off reporting season and largely beat on the bottom line on the back of their volatile trading and capital markets businesses, not on high lending volumes and rising interest rates. The yield curve has expanded since June 26, but that’s only been true this week, when the Treasury Department issued tens of billions of dollars of new long-term bonds, putting supply pressure on the price of these bonds. The KBW Invesco Bank etf (KBWB) - Get Invesco KBW Bank ETF Report is up just 10.5% since June 26, underperforming the market. Bank stock investors know, as do bond investors, rates are bound to stay pressured, especially as the Federal Reserve potentially increase the size of its asset purchasing programs if yields rise too high. Also, banks are tightening lending standards in an effort to shore up cash and protect against poor credit. That pressures loan volumes.
Okay, that was a lot of data and info.
What this all means: the second quarter was likely the worst it is going get in the U.S. during this pandemic and we can expect sequential improvements in earnings every quarter. The recovery is on track. Investors are free to price stocks at the current valuations and let the improving earnings for the next 12 months take stocks up from here.
But it’s not that simple.
Analysts have only revised 2021 earnings estimates upward by a few percentage points, according to Morgan Stanley, with notable strength again in capital goods. Those revisions are shaky as well, especially because the virus situation is an unknown, states have paused reopenings, interest rates cannot fall much from here and the much-needed new round of fiscal stimulus is delayed until at least September.
FactSet says only 45 companies have issued guidance. Most management teams essentially have no idea what business will look like in the coming year. And if the economic recovery hits more snags, which have already occurred, that strong 2021, with 26% EPS growth year-over-year, will be reassessed. "We continue to have doubts about whether S&P 500 profitability will be able to return to pre-coronavirus crisis levels in 2021,” wrote Lori Calvasina, Chief U.S. Equity Strategist at RBC Capital Markets in a note.
The incredible addition to the money supply could stoke economic demand and inflation once a vaccine enters the fray, people get out of their homes more and restaurants and airlines operate at full capacity. But inflation has been stubborn for more than a decade even with ultra low rates.
The point: stocks will move on 2021 earnings projections, so keep watching the pace of the recovery.
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