Will Earnings Be Good Enough To Keep The Market Moving Higher?
Summary
- Earnings season is here, and given the recent stock rally, it seems expectations for earnings are high.
- Companies will need to deliver better than expected results to keep the recent rally moving.
- However, given the current market valuation, guidance will need to be significantly better.
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It seems pretty hard to believe four months ago, the S&P 500 was trading below 3,900, and expectations broadly among investors were that first quarter earnings would be really bad. It set a low bar for investors, and as earnings rolled in better than feared, most stocks were able to rally.
This quarter we find ourselves in a different position. The S&P 500 has rallied by almost 19% since the March 13 low and has seen its PE ratio swell to 19.6 from 17.1. Given the rapid rise in the index over such a short period of time, it seems the second quarter theme should be if earnings will be good enough.
Bloomberg
Earnings Will Need To Be Stellar
S&P 500 earnings estimates for the second quarter are very low, with analysts seeing earnings dropping by 8.9% versus last year to $52.6 per share. Of course, with stocks up so much and the PE multiple so high, the market already appears to have front run second quarter results and expects results to be much better than expected.
Bloomberg
Additionally, the second quarter is, at least for now, expected to be the trough in earnings. Earnings are expected to fall just 1.1% in the third quarter to $55.7 and then rise by 6.4% in the fourth quarter to $57.2. That probably means that companies will need to provide better than feared third quarter guidance to keep stock prices moving so that earnings can catch up to the PE multiple expansion seen since mid-March.
It isn't so much any longer if earnings will come in better than expected clearly given the movement in the market and, more notably, in some stocks, they need to come in not only better than expected, but these companies need to provide guidance that's much better than expected, to get those lower trending earnings estimates for the third and fourth quarter to reverse and trend higher.
If they can start trending higher and catching up with the recent rally in the stock market, then the PE ratio and the valuation for the stock market will begin to fall, making shares at least initially less overvalued. But if guidance isn't much better than expected, and earnings estimates for the third and fourth quarters do not start to turn higher, one must wonder what right stocks have trading at current valuations.
Relatively Not Cheap
Additionally, with bond yields so high, at some point, one needs to wonder when investors flip away from stocks and turn to yields. The inverse of the PE ratio is the earnings yield; a PE ratio of 19.6 equates to an earnings yield of 5.1%. Investors use earnings yield to help them determine how cheap or expensive stocks are relative to bonds. Currently, with the 10-Year nominal rate at 3.8%, the spread is just 1.3%. That's the narrowest the spread has been since 2007. A spread that has consistently been between roughly 3 to 3.5% since 2013. Stocks seem less attractive today, relatively speaking.
Bloomberg
Given the recent market moves, it appears that expectations are for companies to deliver better-than-expected results and more favorable guidance. Therefore, earnings will not only need to come in better, but they also will need to be significantly better than expected to justify the re-rating that has taken place since mid-March. Additionally, guidance must be good enough to turn earnings estimates from trending lower to higher.
If not, the recent rally will likely have been nothing more than a head fake.
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This article was written by
I am Michael Kramer, the founder of Mott Capital Management and creator of Reading The Markets, an SA Marketplace service. I focus on long-only macro themes and trends, look for long-term thematic growth investments, and use options data to find unusual activity.
I use my over 25 years of experience as a buy-side trader, analyst, and portfolio manager, to explain the twists and turns of the stock market and where it may be heading next. Additionally, I use data from top vendors to formulate my analysis, including sell-side analyst estimates and research, newsfeeds, in-depth options data, and gamma levels.
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