Earnings and stock prices appear as if they are decoupling
After the stock rally in the second half of 2020, markets have begun to cool throughout 2021…even though the first quarter of 2021 has been one of the best earnings seasons for management teams on record.
Today, we are going to take a deep dive to understand why stock prices aren’t following this trend in earnings.
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The market is more than three quarters of the way through the first quarter earnings season, the first of 2021.
With most of the S&P 500 having reported first quarter earnings, we can begin to take a look at how corporate America has matched up to analyst forecasts coming out of the pandemic.
So far, a strong 85% of the companies have beaten analysts’ expectations. On average, only 74% of companies have beaten quarterly estimates within the past five years. The economy appears to be accelerating faster than expected coming out of the pandemic.
If earnings continue at this rate, the first quarter of 2021 may set a record for the earnings season with the most positive surprises since the third quarter of 2013, as far back as S&P reports this metric. The prior best was the third quarter of 2013. That quarter saw a beat rate of 83%, putting 2021 on track to be record-breaking.
The highest rate of analysts under-guessing performance has been in the Financial sector, where a staggering 92% of companies have beaten analysts’ expectations.
Thanks to the U.S. and international governments coming in with strong stimulus packages, there have been fewer defaults than expected over the past year, shoring up these Financial names.
Even the weakest industries have done better than expected this quarter. Real estate has been upset dramatically in the past year by the At-Home Revolution, and commercial real estate weakness has pulled down returns. Despite this weakness, 66% of Real Estate companies still beat analyst expectations.
After such an impressive showing this earnings season, investors would logically assume the stock market should be rocketing higher. However, this hasn’t been the case at all.
Since JP Morgan unofficially kicked off the earnings season on 4/14, the stock market is only up 1%, practically flat. This is in stark contrast to the 11% the market was up from January first to the start of earnings season.
To understand this disconnect, we have to peel back the numbers.
As regular readers of Valens Research know, we put little stock in the as-reported financial metrics that companies are reporting on during earnings calls.
While understanding revenue and forward-looking projections is crucial, the earnings power of companies is distorted by GAAP standards. These as-reported metrics fail to show the real profitability of a business.
Thanks to how Uniform Accounting cleans up the accounting noise, we can compare historical returns across different industries on an apples-to-apples basis.
By aggregating the companies that make up the stock market, we can see the historical trend for return on assets (ROA) and what the market is expecting for the future at current market valuations.
As you can see below, Uniform ROA has been cyclical, yet steadily improving over the past twenty years. While returns have fallen during recessions, most notably in 2008 and 2009, huge macroeconomic tailwinds have served to drive up returns across this timeframe.
In the past two decades, the U.S. market has focused more on higher return intellectual property and service-based businesses rather than manufacturing, leading profits to expand.
Furthermore, a constant focus on improving working capital efficiency, taking costs out of the system, and being smart around investing in new ventures has pulled returns up as well.
Unsurprisingly, 2020 placed a pause on this steady increase, with returns falling for the first time in five years.
Now that we have context as to the historical profitability of the market, we can look at what analysts and investors are expecting. As you can see below, analysts are pricing in a record year for 2021, with returns to reach an average of 12%. Returns are then expected to further rise to 13% in 2022.
Meanwhile, the red bar is what the market is pricing in for “mid cycle” returns. As this is a long-term price target, this means the market thinks 12% will be the average returns over the next business cycle.
In other words, the market is already pricing in the next cycle to be the most profitable one in the last 20 years.
It is no wonder then that even after companies and management teams have reported on barn-burner quarters, the market has hardly budged. If record-breaking earnings calls are already being priced into the current market, then it is hard to beat perfection.
This is one of the reasons why as we talked about a few weeks ago, there is a risk for a bumpy market over the next few months.
Joel Litman & Rob Spivey
Chief Investment Strategist &
Director of Research
at Valens Research