Wall Street is disappointed after a record earnings season
Coming out of the pandemic, companies across the U.S. have been roaring back to a reopening economy, and investors are buying into the new world order.
After this stock market run came the first quarter of 2021 earnings season, where companies reported record-breaking results. However, the stock market has failed to respond to this barn burner earnings season.
Over the past few weeks, we have talked at length about why this is occurring. Now, Wall Street is just starting to pay attention.
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On the last day of May, Forbes published an article on a subject we have been highlighting over the past month.
As of the week ending last Thursday, around 98% of the S&P 500 companies had reported first quarter results. This earnings season was a standout, with 85% of names reporting a positive EPS surprise, the highest since the metric was tracked in 2008.
Furthermore, earnings growth itself came in at 51.9% relative to the first quarter of 2020, comparable to an expectation of 23.7% in late March.
However, despite these barn burner results, the S&P 500 has increased by less than a percentage point since earnings began. Meanwhile, the Nasdaq is down 1%.
If this sounds a little familiar to our regular Investor Essentials Daily readers, that is because we have been reporting on this eventuality over the course of May.
Back in the beginning of May, we reported how management teams are less bullish about growth than they were in late 2020. We said this wasn’t a reason to sell, but anticipated flat markets.
We also discussed on the 17th how one metric of investor bullishness, investor credit, is showing exuberance in the markets.
Finally, a week before Forbes, we highlighted exactly why blowout earnings aren’t moving the needle on the market.
While companies have been seeing incredibly strong performances, these results were already “baked in” to the stock price after the 2020 climb.
Furthermore, at current valuations, the market is pricing in the next business cycle to be the most profitable one in the past twenty years. With a market already priced for perfection, it was inevitable for markets to trend flat to down, even with companies overperforming.
Now, let’s expand our scope to get an even better sense of market expectations.
As those prior articles highlighted, one of the key ways we try to get an understanding of market expectations is to look at market expectations for return on assets (ROA).
To get a full picture of what the stock market is pricing in for the future we can look at incremental data too, in particular looking at market expectations for company reinvestment, for asset growth.
At current valuations, investors aren’t just pricing in an all-time high for mid-cycle ROA. Current valuations are also for asset growth to sit at prior cycle levels.
On first blush, growth in line with prior bull markets seems to be neither bullish nor bearish for expectations. However, to understand what this says about investor expectations, we have to pull back the curtain on market history.
Over the past three business cycles, asset growth has on average steadily declined between each cycle, not stayed steady.
After every recession, management teams learn to tighten their belts and become more reticent to invest in new operations. Furthermore, management techniques like lean, six sigma, and others teach them to cut costs out of the business and operate with less working capital and other investment.
In the 80s and 90s, management teams were much more concerned about growth at any cost. Today, board members and investors are holding the c-suite more responsible for making sure any investments have a better return than the cost-of-capital for the business.
In aggregate, this focus on smart investment has benefitted business, and is part of the reason returns have continued to climb after every recession. It has also meant that each cycle management teams grow their companies, on average, less.
This means an expectation for growth to remain flat this cycle may be optimistic for the next five years.
In the cycle through 2006, average growth was around 11%. In the next cycle, growth was around 8%, and in the most recent cycle from 2015 to 2020, growth was only around 5%-6%.
This means with expectations of 6% over the next five years, markets are pricing in a multi-cycle slowing in investment to stop now.
Expectations for future growth may have been a little too optimistic. Additionally, if management teams are less confident about their outlook in the short-term, they may hold off on investing.
As the red bar above shows, the market is not pricing in this reticence at all.
Since investors were already pricing in banner growth in Q1, the growth that happened didn’t push the market higher. If growth is going to be more of a disappointment later this year based on the data we’re seeing now, the market may continue to trade sideways, as actual earnings can catch up with the heightened exuberance coming out of the pandemic.
Joel Litman & Rob Spivey
Chief Investment Strategist &
Director of Research
at Valens Research