The US earnings season is halfway through, and on the surface, it is full of good news. And yet, far from being cheered up by this, markets have been going down. Why is that?
Around 185 companies, with 52% of the total market capitalisation in the US, reported quarterly earnings in January, according to analysis by Deutsche Bank.
Of the S&P 500 index constitutes that have reported results, 85% have beaten market expectations, which is well above the historical average of 73%.
If this keeps up for the whole earnings season, positive surprises will be at a record high, the analysts at Deutsche Bank point out.
The extent to which the companies that have beaten estimates have done so is also impressive. Earnings have been higher than forecast by around 17% in aggregate, the same as for the third quarter and a little under the 20% registered in the second quarter.
As we know, expectations were really depressed in the second quarter of 2020, when the world was in the grips of the first wave of the Covid-19 pandemic, so that 20% figure should be seen in that context.
Looking at the median rather than the average shows that earnings have beaten market expectations by 10% in the fourth quarter, compared with 12% in the third quarter and 16% in the second.
All this sounds really good, so why have markets been falling? The S&P 500 closed the first month of 2021 with rather disappointing performance: it is down 1.1%. On the other hand, the Nasdaq Composite, the technology index, ended January up 1.4%.
This tale of two fortunes gives an idea of some worrying trends in the earnings results so far.
While cyclical companies – apart from financials and energy — beat expectations, they did so by 11%, below the 44% that analysts at Deutsche Bank had expected.
On the other hand, the “secular growth” companies, which include technology stocks, beat by more than the analysts at Deutsche Bank expected (17% versus 7%).
Looking at sectors, financials have posted the strongest beats in the aggregate, at 30%. But these in fact reflect lower provisions that banks have made for loan losses, as various stimulus measures have ensured that individuals and companies kept up their debt payments.
In other words, the banks’ earnings do not reflect real strength, but rather the fact that things were not as bad as originally thought for the financial sector, due to government intervention.
What this seems to suggest is that the economy was in the grips of the Covid-19 pandemic in the fourth quarter as well, with cyclical activity still depressed and technology, the main beneficiary of the lockdowns, continuing to perform strongly.
Good sales, disappointing market reaction
As earnings can sometimes be tweaked to reflect what management wants to show rather than what actually happened, let’s take a look at sales. Here, again, on the surface things look good.
There have been record sales beats in both breadth and size, according to the Deutsche Bank analysis. So far, 79% of companies that reported have beaten expectations, well above the historical average of 57% and, in fact, the highest on record.
New records were hit in terms of size as well, with sales beating by 3.1% in aggregate and by 2.4% for the median company.
The aggregate sales beats have been driven by technology, with 6.4%, materials with 5.2% and financials with 3.6%.
But these stellar results have done little to lift investors’ mood. On the contrary, the market reaction shows there may be worrying times ahead.
Companies that have beaten earnings estimates have “underperformed massively” relative to the market, by 1.3 percentage points compared to a modest outperformance historically of half of a percentage point, the Deutsche Bank analysis shows.
“If sustained, this would be by far the worst earnings season performance of companies that beat in at least 10 years,” the analysts wrote.
Looking at sales results, the same thing happened: companies with positive sales surprises underperformed by one percentage point versus a historical outperformance of 0.7 percentage points.
And those that missed sales estimates have underperformed more severely, by 1.8 percentage points compared to 0.8 percentage point historically.
What this shows is that investors are becoming more aware that valuations have been running way ahead of the reality on the ground.
At the end of the day, the discounted cash flow method is the most concrete way to find out how much money your investment could make over time.
It’s true that central banks have done more than their job to ensure that the interest rate at which these cash flows are discounted is extremely low.
However, with economic activity still depressed it is hard to believe that record high market valuations will be matched by company revenues soon.
A new wave of enthusiasm could sweep the markets once it becomes clear that vaccines are bringing down the Covid-19 pandemic.
But this will probably not happen in the first quarter of 2021, so the market mood could be gloomy for a while yet.