On one hand, the coming earnings season (77% of the S&P 500 market cap will announce results between April 19 and May 7) will be one of the strongest on record at least when measured on a Y/Y basis for the simple reason that Q1 2020 was the first quarter of the covid pandemic. On the other hand, as Deutsche Bank’s Binky Chadha writes, the sellside now expects impressive beats having lifted the bar high enough to where just mere “strong” EPS reports may not be sufficient (incidentally, consensus currently forecasts aggregate sales growth of 5%, margin expansion of 66 bps to 9.9%, and EPS growth of 19%. However, median EPS growth will be only 10%). Finally, as Goldman notes, no matter how strong earnings are, they will not matter and instead all investors will care about is future guidance which however may be quite disappointing due to the recent surge in input costs which could lead to a big hit to projected profit margins.
Starting at the top, we remind readers that the last 3 quarters saw record-breaking beats in S&P 500 earnings, ranging between 14% to 20%, eclipsing even those seen coming out of the 2008-2009 recession as DB’s Binky Chadha shows in the chart below.
The record earnings beats mirrored unprecedented positive surprises in macro data, easily the largest on record in terms of magnitude and approaching the longest ever stretch in duration.
The record surprises in earnings and data in turn have seen Q1 2021 consensus estimates rise by 9.2% since June…
… and by 5.6% just over the past quarter, the largest upgrade going into an earnings season in our sample going back the last 10 years.
The market has also already rallied strongly going into this earnings season. The S&P 500 rally of 7.5% since the end of the previous reporting season in February, is one of the largest on record, and compares to an average +1% historically.
What does the consensus now expect?
The bottom-up consensus sees Q1 earnings rising a robust 22.6% yoy, significantly higher than 2.9% in Q4 2020, but this growth is greatly exaggerated by the low base in Q1 last year.
Relative to Q1 2019, the consensus sees earnings rising 1.9% on an annualized basis. This compares poorly to the historical long-run trend rate of 6.5%. Median company growth is expected to be 10.9%, a little higher than 9% in Q4.
A far different picture emerges when earnings are looked at sequentially (i.e., compared to Q4 2020) where earnings are expected to fall -5% qoq. However, Q1 is typically a seasonally weak quarter, and adjusted for seasonality, growth is expected to be +3.4% qoq.
Around half of this increase comes from higher oil prices which should boost Energy earnings. Excluding Energy, the consensus sees growth of a modest 1.5% qoq on a seasonally adjusted basis, following +27.1% in Q3 and +8.6% in Q4 in the last 3 quarters.
Is the bar high enough?
The bar for Q1 2021 earnings has been raised significantly more than it was for the last 3 quarters, when consensus was unambiguously far too low and out of sync with massive upswings in activity and macro data surprises.
Is it high enough, as the DB chief equity strategist? At the top-down level, he notes that the 1.5% growth (ex- Energy) over Q4 that consensus expects is equal to the GDP growth expected by DB’s US economists, and thus looks far too low considering a typical multiplier of 4x. At a more granular level, DB evaluates consensus estimates through the lens of its framework based on 4 groups of stocks and sectors defined by very different trend growth and cyclical sensitivities to macro growth and the dollar: (i) the secular growers (mega-cap growth and Tech), (ii) the defensives, (iii) cyclicals with a trend and (iv) cyclicals without a trend.
- The bar has been raised the most for the secular growers. Blockbuster beats last season saw large upgrades (+10%) to Q1 estimates for the secular growers. The consensus has already largely accounted for not only the strong underlying trend but also the cyclical boost from stronger macro growth, and sees earnings rising above long-run trend levels. With the bar already raised substantially, beats for this group are likely to be below their historical average and at the lower end of the range (+4%).
- Defensives earnings already back at trend levels. Earnings for the defensive sectors already rose back up to trend levels in Q4 and are seen rising in line with it in Q1. Beats for the defensives have historically ranged from 2.5% to 6.5%. However, delivering even average beats would need earnings to rise significantly above trend, which are seen as unlikely. Instead beats are likely at the lower end of the historical range (+2.5%).
- Energy should post large beats, but off of a low base as estimates do not look to fully reflect the move up in oil prices. Oil prices rallied strongly in Q1 to average $60 a barrel, up from $44/bbl in Q4. While estimates for the sector have been revised up significantly since January (142%), there is room for them to rise further, pointing to a fairly large beat in earnings, albeit off of very low levels.
- Financials provisions key. After posting massive provisions for loan losses in Q1 ($44bn) and Q2 ($54bn) last year, provisions moderated to near average levels in Q3 ($11bn) and to near zero in Q4 as a few banks even began releasing reserves. The consensus, however, expects a rise in provisions in Q1 ($6.6bn) despite the strengthening macro backdrop. That said, even a conservative assumption of no additional provisions implies significant beats for the Financials (+8%) with the risk to the upside.
- Other cyclicals. Large concentrated losses in pandemic-hit companies are unlikely to see significant improvement in Q1, and will continue to be a drag on cyclical earnings. For the remaining cyclicals, consensus sees earnings rise only modestly (+3% qoq on a seasonally adjusted basis). Given the sharp increase in macro growth in Q1, Deutsche Bank views the consensus as too low and expect large beats (+15%).
Overall, DB sees S&P 500 earnings coming in 7.5% above consensus. While lower than the record surprises over the last 3 quarters, this would still be well above the historical average (+4.5%).
Will such a “beat” to expectations be sufficient to push stocks even higher? Don’t bet on it, if Goldman’s David Kostin is right.
According to the Goldman chief equity strategist – who notes that consensus currently forecasts aggregate sales growth of 5%, margin expansion of 66 bpto 9.9%, and EPS growth of 19%. However, median EPS growth will be only 10% – from a sector perspective, Consumer Discretionary is anticipated to pace the market with 97% year/year EPS growth powered by an 11% rise in sales. The stellar growth in part reflects the contribution of AMZN and TSLA. At the other extreme, Industrials on an aggregate sector basis will witness a revenue decline of 2%, roughly 100 bps of margin contraction, and a year/year EPS drop of 17%. But the median stock will actually post EPS growth of +9% as Airlines are a headwind to aggregate sector growth.
While this is great, Kostin then cautions that “backward-looking performance metrics have been ignored by most investors for the past year.” Consider that in 4Q 2020, fully 62% of S&P 500 firms reported EPS more than a standard deviation above consensus, ranking just behind 3Q 2020 as the best quarter in at least 23 years. However, the median stock beating estimates actually lagged the index by 85 bps on the subsequent day! This represented the weakest post-report performance on record, extending the pattern exhibited during the 2Q and 3Q 2020 seasons.
As Kostin puts it “simply”, the trajectory of the economic recovery will continue to make backward-looking metrics less relevant for the forward-looking market. Underscoring this point, firms providing EPS guidance more than 5% above consensus estimates outperformed as usual, by a median of 115 bps.
In short, the past quarter is already fully priced in – and expected to be spectacular – which is why actual earnings may only disappoint. Which means, the only upside will come from stellar commentary and even stronger guidance for the rest of the year.