Earnings: A Roadblock in the Recovery?

Stocks have staged one of the most impressive rallies in recent history, despite a wall of uncertainty.

Proactive policy measures, hope for a quick economic restart and coronavirus drug development fueled the rebound. Potentially threatening the recent move is the start of first-quarter earnings season, which could be the S&P 500 Index’s worst in 11 years. Even as investors continue to look past a stretch of negative economic headlines, there are early indications that this particular earnings season may be a lot for the bulls to swallow.

Why do earnings matter?

Quarterly earnings reports are one of the best tools we have to measure corporate America’s financial health. While economic data is used to gauge broader trends, earnings reports generally provide more granular details on how industries and individual companies have fared in recent economic conditions. The stock market typically responds in a similar way: economic data releases may move large swaths of the market at once, but company earnings tend to affect single stocks. This is because a company’s earnings, and its potential to grow those earnings, are directly reflected in its stock price. These more localized moves can eventually add up, though.

Stocks normally respond to how earnings results compare to estimates from a consensus of Wall Street analysts. This time around the bar is historically low for companies’ earnings growth, or lack thereof. Wall Street firms estimate S&P 500 profits dropped 12.5% year over year in the first quarter, which would be the biggest slide since 2009. From there, analysts expect earnings to fall as much as 27.4% in the second quarter, the quarter expected to be most negatively impacted by the coronavirus pandemic. Sales forecasts aren’t as pessimistic – Wall Street thinks revenues were flat year-over-year in the first quarter, before falling 7% in the second quarter. A sales decline that isn’t as deep as the earnings decline indicates that analysts’ top line (sales) forecasts might be too rosy, leaving room for disappointment from investors when results are reported.

Seven of 11 S&P 500 sectors could report year-over-year profit drops, according to estimates. The energy sector likely suffered the biggest earnings blow in the first quarter, as estimates suggest profits slid 62% in the first quarter. Oil prices declined 66% during the quarter and profitability of the sector is highly correlated to oil prices. Consumer discretionary and industrial earnings are also expected to be abysmal.

Lowering The Bar

A lower bar could be a good thing, as it’s easier for companies to surpass expectations. However, the opposite is also true – companies that miss unusually low forecasts could get punished by stock investors.

So far, the results have been mixed. Banks, which usually kick off each earnings season, missed profit estimates across the board as they set aside money for expected loan losses. Not surprisingly, financial industry stocks comprised one of the worst-performing sectors in the S&P 500 this week. On the other hand, health insurance companies (like Progressive Corp. and UnitedHealth Group Inc.) and pharmaceutical companies (like Johnson & Johnson) largely beat first-quarter profit estimates.
Executives’ commentary on future earnings could be even more telling. The operating environment has changed dramatically since the last earnings season (that started in January), and we haven’t had many chances to hear from management on how their companies are weathering the storm. On top of that, many S&P 500 companies have withdrawn profit forecasts over the past several weeks. It’s an understandable trend, given the operating uncertainty from the coronavirus outbreak. Still, that means investors will be listening extra closely this earnings season for clues on what to expect going forward, especially with regards to the return of demand and plans for returning employees to their offices. This may be the best way to project how quickly the economy can come back online.

Something’s got to give.

Of course, investors have been looking forward to better days, and the stock market is a leading indicator for the economy. Because of this, it’s natural to think markets could shake off a few quarters of bad earnings data as well.

However, history shows stocks can lag the earnings rebound. In the bear market of the early 2000s the stock market low wasn’t reached until October 2002, about two quarters after 12-month trailing earnings bottomed (or the year-over-year change in average earnings for the past four quarters). During the financial crisis, the S&P 500’s bear market bottomed about the same time as 12-month trailing earnings. Based on current earnings estimates, a 14.8% decline is projected for 2020. If that is the bottom in earnings growth, the limited data we have suggests the bottom in the market could be up to two quarters away.

Valuations are also getting stretched, even amid rampant uncertainty. On Thursday, the S&P 500 closed at 20 times on a forward price-to-earnings (P/E) basis. That’s the highest forward P/E ratio since May 2002 (right before the benchmark dropped 30% in five months).

Something’s likely to give. We’re happy to see stocks recovering from a fast and furious drop, but investors may be getting ahead of themselves. We still have little information on when a re-start of the economy will happen and what that would look like. Overall, we’re still anticipating another bout of volatility before stocks’ definitive push to new highs.

The opinions expressed here are not meant to be used as investing advice. For more information, visit our website.
 

Lindsey Bell is Ally’s Chief Investment Strategist, responsible for shaping the company’s point of view on investing and the global markets. She is also President of Ally Invest Advisors, responsible for its robo advisory offerings. Lindsey has a broad background in finance, with experience on the buy-side and sell-side, in research and in investment banking and has held roles at JPMorgan, Deutsche Bank, Jefferies, and CFRA Research.

Lindsey holds a passion for teaching individuals how to become successful long-term investors. She frequently shares her knowledge as a guest on national news outlets such as CNBC, CNN, Fox Business News, and Bloomberg News. She also serves on the board of Better Investing, a non-profit organization focused on investment education.