The lifeblood of the equity market is the profits generated by the companies in the index. As we approach our Q3 2021 corporate results, we discuss the current configuration of the land (stock market and valuations).
Sometimes the market pays more for these gains (like nowadays), sometimes less. For example, over the past decade, the price / earnings ratio (PE or market multiple) of the S&P 500 Index has ranged from 10.3 to 23.2, with the current level at 21.1. This is based on 12 month consensus estimates for profits. The Canadian TSX has a similar range, 10.8 to 20.8, although its current PE ratio at 16x is not in the upper range.
The amount that the market will pay or assess $ 1 in earnings changes frequently, and sometimes quickly.
The market multiple is influenced by many factors, including bond market returns, as it is an asset class competing with equities. Historically, higher returns have coincided with a lower PE ratio for the equity market. I mean, if you’re going to get, say, a 5% guaranteed coupon on bonds, you won’t be paying that much for a dollar in income given all the extra uncertainties with stocks. With low returns these days, equity capital-to-equity ratios tend to be higher.
However, the main driver of the market multiple is perspective. If the economy is doing well, with few clouds on the horizon, the PE ratio tends to be higher. When uncertainty about the future path of the economy increases, investors will not pay as much for profits because the future path becomes less certain.
In 2019 and 2020, market returns were primarily driven by multiple expansion. Yes, even during this rapid bear market, which saw rapid multiple squeeze, followed by even more incredible multiple expansion. The chart above breaks down the annual returns of the S&P 500 and TSX including dividends, earnings growth and the change in multiple. The red bars represent changes in the market multiple, by far the main driver of the index’s performance over the past two years. Please note that while earnings and dividends increase over time, the market multiple does not increase; it is a zero sum game. In other words, the multiple expansions are offset by the multiple contractions of the other years.
We started to see multiple contraction after a few years of expansion in 2021. So what does this mean for third quarter 2021 corporate profits?
The good news is that earnings growth has come to the rescue of the market. The 12-month consensus earnings for the S&P 500 were $ 166 at the start of 2021; it is now $ 214 for the next 12 months. Initially, earnings only rebounded from depressed levels, but in recent quarters it was the stronger-than-expected economic recovery that pushed estimates even higher. Rising profits heal or alleviate many ailments in the market. Higher yields, Fed cut, China real estate problem; if there is enough profit growth, the market will not care as much.
So why are we talking about earnings? The growth in earnings, or more specifically the rise in earnings expectations, drove the market returns in 2021 (big yellow bars in the previous chart). Reopening economies, rising commodity prices, and surprisingly robust demand growth focused on durable goods rather than services have created the perfect elixir for S&P and TSX earnings. A 29% increase in term profits from nine months ago is the fastest pace we’ve seen in a long time. The TSX at 24% is not left out either. But, in the last few weeks, we’ve started to see earnings estimates start to drop. Don’t worry too much, it’s not the earnings growth that is turning negative, the estimates are only dropping.
Currently, the S&P 500 is expected to earn $ 198.62 for 2021 (two quarters in the bag, two to go). And next year, the upward consensus estimate is $ 218.03. Clearly positive, despite a slower pace of earnings growth (+ 10%).
These estimates began to decline, reversing an upward trend in estimate revisions that had been the trend. Over the past year, the trend in estimated forecasts has been increasing. But in mid-August that trend came to a halt and in September, analysts revised their earnings forecasts downward (chart on the right). A subtle drop, but the new management is not encouraging.
Some slowing in economic growth is one factor, but rising costs are another. Last week, Fedex Corp, often an indicator of economic activity, pointed out that while demand and prices remain healthy, costs are now rising faster and offsetting the good news. Shares fell 8% on the news.
Digging deeper into third-quarter 2021 corporate earnings, which will begin reporting in early October, negative revisions appear to be more common in a few sectors, with consumer discretionary being the hardest hit. Several factors are contributing to this, including automobiles, which experience supply chain disruptions. Additionally, as the economy reopens and consumers start spending more on services, it has the side effect of spending less on durable goods (an important component of consumer discretionary). Industrials saw the second largest drop in estimates and this is likely to spread as analysts update their forecasts from the lower Fedex forecast.
There is a silver lining in these US trends in the industry’s third quarter earnings revisions. The TSX, given its higher weighting in energy, materials and financials, should be less affected, assuming industry trends are evident across the border. In fact, that is also what the numbers show. Revisions to estimates for the TSX Q3 earnings season have not seen the same rate of negative revision as the US market. Come on Canada.
Earnings growth and positive revisions have helped stock markets advance over the past year. Unfortunately, this positive impulse seems to be fading. While negative revisions have been minor so far and earnings growth remains positive, the upcoming third quarter earnings season might not be fun. The last season of earnings has witnessed a far above normal rate of positive surprise in terms of the frequency of companies exceeding estimates and the magnitude of those “beats”. As costs continue to rise and the rate of revenue growth slows, companies better able to control costs and / or pass costs on to customers should fare better.
Since markets tend to focus on the second derivative of change i.e. earnings growth rate slowing down, as opposed to lower earnings themselves, could inject more negative volatility into prices, especially on earnings days.
As we noted above, rates matter too, and this week saw a sharp jump in one-day yields. They are arguably still low, but the upward trend in rates that started in Q2 2020 appears to be resuming after a five-month hiatus.
We also refer you to Ethos from last week, where we discussed inflation and pointed out that wage inflation in particular would be something to watch out for. Firms that employ a lot of people and have labor as one of their most important input costs could be more affected than most. Both because of the difficulty discovery workers, but also the increase in the cost of their remuneration.
Additional attention should be given to holdings or exposure to consumer discretionary, industrials and consumer staples. Estimates in these sectors are being revised downward for good reason. Having less exposure or favoring more defensive positions in these sectors may prove to be prudent as we begin to go through more difficult earnings seasons.
Source: Charts are sourced from Bloomberg LP, Purpose Investments Inc. and Richardson Wealth, unless otherwise noted.
All opinions expressed here are solely those of the authors and do not represent the views or opinions of any other person or entity..