U.S. finance television likes to tout earnings beats and misses during the quarterly reporting season because it makes corporate profit growth feel more like a sporting event, where every company is either a winner or a loser relative to forecasts. So far, with 371 out of 500 S&P 500 companies having reported, there seems to be a lot to get excited about – earnings are coming in an impressive 17.4 per cent above analyst estimates.
But in actual fact, U.S. profits are still weak. Very few sectors have shown significant profit growth – some aren’t even halfway back to 2019 levels. At the same time, the second wave of COVID-19 cases in North America and Europe is threatening the expected 2021 profit recovery.
The accompanying charts highlight the stark contrast between earnings surprises and year-over-year profit growth. Overall, profits are down 8.2 per cent despite earnings coming in more than 17 per cent above expectations.
The dichotomy between earnings surprises and profit growth is most evident in the energy sector. The first chart shows that earnings for the sector have been announced 80 per cent above (admittedly low) expectations. The second chart doesn’t show much of anything for energy sector earnings – profits are so far below 2019 levels that Bloomberg can’t even assign a number, instead the sector gets an “N/A."
Industrials is the other sector where profit growth remains scarce while earnings surprise to the upside. With 62 of 73 stocks having reported, profits are down almost 53 per cent but more than 37 per cent above expectations.
A market rallying despite negative profit growth is an indication of rising investment risk but it’s not necessarily a harbinger of market disaster. Investors are clearly banking on a profit snapback in 2021 as lockdowns end and a vaccine is distributed. The recent surge in COVID-19 cases, however, particularly in Europe, the U.S. and the U.K., implies that for many companies, a profit recovery to 2019 levels may be delayed.
So far, analysts have not responded to new virus outbreaks with cuts in profit estimates. The consensus forecast for S&P 500 earnings for the upcoming fiscal year bottomed in May at US$125 a share and now stands at US$138.
Any cut in forward earnings estimates could have very negative effects on equities because U.S. stocks are already expensive. The S&P 500′s forward price-to-earnings ratio stands at 24 times, well above the 10-year average of 17.
Profits could recover just as fast as the pandemic shut things down earlier in the year – current market pricing is not obviously delusional. On the other hand, the pandemic’s second wave (as flu season begins no less) and an already expensive stock market make the outlook precarious. Investors need to look past the excitement of earnings season’s beats and misses to carefully assess the profit outlook for their investments.
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Scott Barlow