Look at the Wall Street forecast, and the pandemic increasingly appears to be little more than a wasted year. The S&P 500 earnings per share forecast this year has almost returned to its early March 2020 level, before the reality of Covid-19 put red lines in everyone’s outlook.
As the earnings season begins, two things stand out: how much improvement in earnings has mattered this year and how much disappointing earnings have mattered in recent years.
Start with this year. Operating profit for 2021 is expected to be 14% higher than analysts’ forecast in early January, and the S&P is up 16%. Higher profits in 2021 seem to almost perfectly explain the rise in stock prices.
Yet look back and the explanation collapses. Profits are still expected to be lower this year than expected in February 2019, when Refinitiv began collecting the Wall Street average for 2021. If the market moved only with the annual earnings forecast, stocks would be about a tenth less than expected. ‘they were not. then, but in fact the S&P is 60% higher.
Why are earnings important this year when investors have paid so little attention in the past? The answer has three parts.
The first is that forecasting two-year earnings is little better than guesswork, and everyone knows that. Every year since 2013, the average Wall Street departure forecast collected by Refintiv was 11-12% higher two years ahead than a year ahead, regardless of the economic, political or financial situation. When the forecast started collecting for 2023 in February, it was again 11% higher than the 2022 forecast at the time. So in 2019, those 2021 predictions had little credibility.
The second is that the effects of the pandemic are still with us. Investors correctly concluded that last year’s slump in earnings was temporary, and stocks rallied even as 2020 earnings continued to devalue. This year, many businesses will be hampered by supply chain disruptions, hiring challenges, and higher labor and raw material costs. Investors assume that the impact of these issues on inflation is temporary; if they are right, so is the effect on earnings, meaning that it is possible to continue the recovery in earnings as the disruptions subside.
Finally, this year is quite different from the previous two years, as investors have focused on the outlook for cheap or value stocks. Business profits undermined by containment, like banks and airlines, have rebounded, making their stocks more attractive. But investors don’t think their long-term prospects are any better than before the pandemic. They are still not valued to generate growth and their valuations are slightly down, measured in terms of price versus 12-month earnings.
Prior to this year, investors focused on growth stocks, which meant that in 2019 and 2020 rising valuations were the primary driver of prices, not earnings. Valuations surged as enthusiastic investors anticipated strong growth in the future, aided by falling bond yields, making distant earnings even more valuable.
It couldn’t last, and the combination of the near-term recovery and higher bond yields, at least earlier in the year, helped stock beat growth.
The results season could give us some clues on all three elements.
First, we should be able to think more clearly about profits next year with more evidence of how things have gone. Second, CEOs are likely to give us clues about how temporary they believe the post-pandemic disruption is. (I guess: this will last longer than the Federal Reserve thinks, but will still be temporary.)
Finally, CEOs of cheap companies reporting higher profits will surely try to convince us that they have restarted their outlook, and therefore deserve a higher valuation; Some growing businesses that have benefited from home spending will have a hard time showing that they are on the path to permanent expansion and may deserve a lower multiple.
One thing that won’t change: In a market dominated by companies with long-term prospects, bond yields are still likely to matter more to investors than quarterly earnings reports.
Write to James Mackintosh at [email protected]
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