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Bank towers on Bay Street in Toronto's financial district.Adrien Veczan/The Canadian Press

Earnings season begins with stock markets red hot, valuations rich, and investor enthusiasm off the charts. Expectations are high. But probably not high enough.

Throughout the pandemic, analysts and forecasters have struggled to keep pace with the explosive rebound in economic activity and corporate profits in both Canada and the United States.

As a result, the corporate sector has consistently posted results well ahead of expectations, providing markets with a steady drumbeat of positive news, thereby reinforcing investors’ upbeat sentiment.

Investors have reason to believe this pattern will continue as first-quarter results start to flow. The set-up is especially bullish for cyclical sectors, such as resources and financials, which make up the bulk of the Canadian stock market.

“This earnings season for Canada, you’re going see some big, big beats,” said Ryan Bushell, president and portfolio manager of Toronto-based Newhaven Asset Management. “Expectations are going to catch up to reality, but not at least for another couple of quarters.”

The persistent gap between forecast and actual results is a product of a global economic catastrophe averted.

This time last year, with COVID-19 vaccines a distant hope, the prospect for irreversible global economic harm was being factored into the average long-term growth outlook. That impairment filtered down to earnings estimates for companies across the spectrum of industries.

All of that pessimism takes time to unwind.

For this year’s first quarter, for example, total earnings for companies in the S&P/TSX Composite Index are currently estimated to rise by 51 per cent year over year, according to Refinitiv data.

Last April, Bay Street’s first-quarter estimate was for just 4-per-cent growth, suggesting little change from the crash in earnings brought on by the first wave of infections and subsequent lockdowns.

From 4 per cent to 51-per-cent earnings growth is an enormous revision, and yet some analysts say it’s still too conservative.

Evidence of a global economic boom is growing by the day. Indicators ranging from retail sales to unemployment claims to manufacturing activity point to improving growth. The Institute for Supply Management said its index of U.S. factory activity in March hit its highest level in 37 years. A few weeks ago, the International Monetary Fund hiked this year’s global growth estimate to 6 per cent, up from 5.5 per cent.

“While a third wave of COVID-19 cases could impact near-term prospects in some regions, vaccination is making progress, monetary and fiscal supports remain huge, and appetite for some normalcy return is strong,” Hugo Ste-Marie, a strategist at Scotia Capital, wrote in a recent report.

That calls for an upgrade to earnings estimates for the Canadian market, which has a high level of correlation to the economic cycle, Mr. Ste-Marie said, raising his forecast for TSX earnings growth to 43 per cent in 2021, up from 34 per cent.

“It’s easier to see upside potential for the TSX relative to the S&P 500, with much less demanding valuation metrics,” he wrote.

The global attraction to the U.S. stock market, with its abundance of technology and internet giants, has pushed valuations to levels not seen since the dot-com boom. The S&P 500 index is trading at roughly 23 times forward earnings estimates, compared with a long-term average of around 16 times.

With stock prices that rich, the U.S. market is highly susceptible to disappointment, said Stephen Lingard, the head of investment research of CI Investments’ multi-asset team.

“The fact that they’re blowing out expectations, I think you need to see that for these multiples to be sustained,” Mr. Lingard said. “If we don’t have beats, you could see more multiple compression.”

That’s one possible reason the U.S. market has stopped rewarding positive earnings surprises, with the average stock underperforming the market on the day of its earnings announcement in recent quarters.

The comparable price-to-earnings ratio for the Canadian benchmark index, however, sits at just 15.5 times. Assuming a reasonable expansion of TSX valuations to an average of 16.75, that would see the S&P/TSX Composite Index rise to 21,100 by year end, Mr. Ste-Marie said. That implies further upside of about 9 per cent, building on the index’s 11-per-cent gain so far this year.

Canada’s resource industries have generated some of the market’s strongest gains, as the global commodity complex has stormed back over the past year. Since last April, the Bloomberg Commodity Index has gained 45 per cent, reflecting an updraft in the price of copper and other base metals, as well as oil and gas.

The price of West Texas Intermediate in the first quarter was up by about 35 per cent from the previous quarter, while Western Canadian Select gained closer to 45 per cent. Just since the end of the year, the TSX energy sector’s first-quarter profit estimates have been raised by almost 60 per cent, and the group of stocks is still a strong candidate to beat the Street, Mr. Ste-Marie said. “Energy stocks could enjoy the wild crude oil ride, especially since production continues to recover from 2020 lows.”

The financials sector, meanwhile, is typically a good bet to beat expectations. Last quarter, the big banks marked a full recovery from the pandemic with total profits exceeding precrisis levels. One favourable trend across the group was the drop of loan-loss provisions, as the worst fears about bad loans failed to materialize.

In response to the pandemic, the banks set aside about $30-billion in provisions. Rob Wessel, managing partner of Hamilton ETFs, a fund manager that focuses on financial stocks, said between $6-billion and $8-billion of those reserves should be released over the coming quarters, which flow directly to the bottom line.

“We expect modest reserve releases this quarter, followed by much larger releases once it is clear the economy is reopening,” Mr. Wessel wrote in an e-mail.

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