Loss, Strain & Butterflies: Earnings Plunging, Stocks Ignoring
Profits are central to stocks’ long-term returns, but they often disconnect; with stocks typically leading turns in corporate earnings.
Valuation analysis—futile with today’s rapidly-plunging earnings estimates—is also significantly colored by investor sentiment conditions.
The spread between bottom-up and top-down estimates for S&P 500 calendar year earnings is exceedingly wide; with bottom-up analysts stymied by disappearing guidance.
The relationship between corporate earnings and stock prices is quite a bit more complicated than what’s inferred by classic phrases like “earnings are the mother’s milk of stock prices.” There are times they are glued at the hip; but others when they move in completely opposite directions—even if over the long run, profits are central to stocks’ returns. Even valuation—in this case, as measured by the price/earnings (P/E) ratio—has a murky filter over it.
Valuation = sentiment indicator
Yes, it’s easy to quantify the P (of a stock or an index) at any point in time; and yes, it’s easy to quantify the E at any point in time (certainly trailing earnings, which are already in the books). But the reality of valuation is that it’s as much a sentiment indicator as it is a “fundamental” indicator. It was the euphoria of the time that had investors willing to pay nosebleed multiples for the S&P 500 in late-1999 and early-2000; while it was the despair of the time that had investors unwilling to pay even single-digit multiples in late-2008 and early-2009.
In the COVID-19 world in which we are all living, trying to do anything resembling traditional earnings and/or valuation analysis is proving to be a somewhat-futile task. But the questions have been coming at me at a fast pace from investors and the media as to how/why the stock market could have rallied so significantly off the March 23 low in the face of what is likely to be the disaster-to-come for corporate earnings. So let’s see if we can unpack things a bit.
We are still early in first quarter earnings reporting season with only about 10% of companies having reported. However, even if we were further along, it would still be the case that reports for the quarter that’s already past will be less relevant to assessing the health of corporate America, given that two of the three months were largely pre-COVID-19 economic shutdowns. As is even the case in a normal environment, what companies have to say about their near-term future is more impactful than what they said about the quarter in the rear-view mirror.
In aggregate, S&P 500 companies have so far reported earnings that are 6.3% below expectations, which compares to an average of 3.3% above expectations since 1994. But it’s the forward-looking estimates that are more relevant given the current environment. You can see in the table below the tally of growth rate estimates on a quarterly basis for the overall S&P 500 (bottom row) as well as each of the 11 S&P sectors.
Source: Charles Schwab, Bloomberg, I/B/E/S data from Refinitiv, as of 4/17/2020. Estimates of future earnings are hypothetical and for illustrative purposes only.
What’s most important about the table above is that it has been changing every day—literally. A record percentage of companies have opted to suspend guidance to Wall Street’s analysts altogether given the uniquely acute uncertainty with regard to the outlook. As such, analysts are flying somewhat blind—other than knowing they need to keep revising down their estimates. Look in particular at the hit already to the energy sector—and those horrific expectations predated the plunge in the WTI crude oil price to less than $12 per barrel as of this morning (it was $62 a year ago).
Those so-called “bottom-up” calendar year 2020 estimates—which have moved, in dollar terms, from $177 in early-January to $141 today—remain significantly higher than so-called “top-down” estimates often put out by macro analysts, strategists and/or economists. If $141 is accurate (it’s likely not), that would be a 13.5% decline relative to 2019’s earnings of $163. In the case of top-down estimates for this year, there are some as low as $90 (from EvercoreISI) as an example; which would be a 45% plunge relative to 2019.
E’s plunge competing with P’s plunge
Tying this uncertain earnings outlook to where the market is currently trading, in the chart below I’ve tracked the forward P/E (yellow line) since the beginning of 2020, along with Refinitiv’s bottom-up estimates for calendar year 2020 earnings (blue line). I will regularly update this chart and post it on Twitter, so make sure you follow me @lizannsonders.
As you can see, between January and mid-February, both lines were fairly steady—with about $177 expected for earnings and a forward P/E of between 18 and 19. The P/E at the time was cited as a risk factor for stocks given that it was elevated relative to a long-term historical average of around 16. Then we hit the peak in the stock market in mid-February; which initially saw stocks plunge to a greater degree (both in duration and magnitude) than earnings estimate adjustments—taking the forward P/E down to a very “cheap” 13.3. But talk about a false read at the time. It only reached that low level due to the delay in earnings estimates “catching down” to the decline in the stock market.
P/E Surged as Earnings Plunged
Source: Charles Schwab, Bloomberg, I/B/E/S data from Refinitiv, as of 4/17/2020.
Since the most recent S&P 500 low on March 23, stocks have rallied sharply, while earnings estimates continue to get slashed—meaning the market is now more expensive than it’s been all year given the compression in the E part of the equation. If we were to plug in the lowest estimate I’ve seen for top-down 2020 earnings—the $90 that EvercoreISI is expecting—the current multiple of 20.4 would instead become more than 31.
This all highlights how fleeting current assumptions of earnings growth will continue to be. It’s to be expected given that all analysts, economists, investors are essentially flying blind in trying to gauge the ultimate impact of COVID-19 and the attendant economic shutdown on economic growth and/or the earnings outlook. It’s becoming trite to say, but we are in completely uncharted territory here; with the virus dictating the duration and magnitude of the economic impact.
In the meantime, we can try to get some color with anecdotal and survey-based data, in the absence of precise guidance from companies. In the latest Institute for Supply Management (ISM) survey, gathered during the second half of March, we got the following key tidbits (among others) from the companies they surveyed:
- 47% reduced revenue targets
- 36% reduced capital spending
- 57% seeing decreased demand for products
- 50% jump in demand for health care and social assistance
- Companies which already started diversifying their supplier bases due to tariffs’ impact now more equipped to address impact of virus on supply chains
- Domestic manufacturing operating at 79% of capacity; Chinese at 53%, and European at 50%
- Average lead times for inputs across most major global regions, including United States, up at least 200%
- 54% will delay hiring this quarter, 33% will reduce hours and 24% will reduce headcount
Bottom-up and top-down competing for title
Assuming the trajectory for earnings more closely mirrors bottom-up estimates, the rally in stocks may not be overdone or overly speculative. History shows that stocks typically move in advance of both economic and earnings inflection points—topping before earnings roll over, and bottoming before earnings start moving back up. This is especially the case when exiting a bear market; like in 1957-1958, 1971, 1975, 1982-1983, 1990-1991 and 2009-2010. The only post-1950 exception was in the aftermath of the dot-com bubble bust—earnings bottomed in early-2002, but stocks didn’t bottom until later that year.
Notwithstanding history’s illustration of stocks typically rebounding before earnings, if the significantly-weaker top-down earnings forecasts prove to be closer to reality, it’s likely the rally has taken stocks too far relative to their near-term earnings expectations. Another risk is that top-down estimates do not assume a V-shaped recovery; while bottom-up estimates do (notice the jump in the table above from four quarters of negative earnings to more than +17% for next year’s first quarter).
Beneficial post-COVID-19 side-effect?
Tangentially, there is a possible positive post-COVID-19 side effect of the current rash of withdrawn guidance. It was well publicized two years ago, when Warren Buffett called for companies to stop providing quarterly earnings guidance—arguing it exacerbated the problem of “short-termism.”
Focusing Capital on the Long Term (FCLT) Global is a not-for-profit organization founded to encourage a longer-term focus in business and investment decision making. In an editorial last week in Investor Relations magazine, Sarah Keohane Williamson, FCLT’s CEO, wrote that the withdrawal of guidance by so many companies is “a step in the right direction … regardless of the circumstances that caused them to arrive at that decision.”
Citing a 2015 Harvard study, Williamson wrote that companies that emphasize quarterly earnings guidance get “the investors they deserve. Focusing on short-term metrics attracts transient, short-term shareholders, ultimately increasing share price volatility. It is linked to lower earnings growth, a higher cost of capital and a lower return on equity when compared with peers that issue guidance with a long-term orientation.”
It’s becoming clear that investors don’t necessarily want or need short-term guidance: “In repeated surveys of the buy side, earnings guidance given for periods of less than one year was consistently deemed irrelevant in evaluating a company’s future prospects.” In fact, even pre-COVID-19 corporate America was heading in that direction. Only about 20% of companies in the S&P 500 still provide quarterly guidance. As noted in an article by Bob Pisani on CNBC.com (somewhat ironically): “It seems like there is more [than 20%] because the media tends to focus on those that miss and those that don’t.”
Net negative revisions
In sum, stocks and earnings don’t always travel in the same direction. However, net earnings revisions do tend to track more consistently with how stocks are performing; and my best guess is that there are more downward earnings revisions to come. During the four weeks leading into earnings season, according to Bespoke Investment Group (BIG), analysts raised earnings forecasts for only 88 companies in the S&P 1500; while they lowered forecasts for 1236 companies—working out to a net negative 1148 or 76.5% of the index. Perhaps I’m being naïve, but I would think the ride will remain quite bumpy—at least throughout the remainder of earnings season.