Q3 Earnings Season Is No Cake Walk

The life blood of the equity market is the earnings generated by the companies in the index. Sometimes the market pays more for these earnings, like these days, sometimes less.

Q3 Earnings Season Is No Cake Walk

The life blood of the equity market is the earnings generated by the companies in the index. Sometimes the market pays more for these earnings, like these days, sometimes it pays less less. For instance, over the past decade, the price-to-earnings (PE or market multiple) for the S&P 500 has ranged from 10.3 to 23.2, with its current level at 21.1. This is based on forward 12-month consensus estimates for earnings. Canada’s TSX has a similar range—10.8 to 20.8—although its current PE ratio at 16x is not in the upper range. Attempting to understand how much the market will pay or value $1 of earnings clearly changes, and sometimes it changes fast.

Many factors influence the market multiple. Yields in the bond market have an influence, given this is a competing asset class to equities. Historically, higher yields have coincided with a lower PE ratio for the equity market. I mean, if you are going to receive, say, a guaranteed 5% coupon from bonds, you won’t pay as much for $1 of earnings given all the added uncertainties with equities. These days with low yields, equity PE ratios tend to be higher. However, the economic outlook is biggest driver of the market multiple. If the economy is doing well, with few clouds on the horizon, the PE ratio tends to be higher. When there is uncertainty about the future path of the economy, investors won’t pay as much for earnings.

In 2019 and 2020, market returns were predominantly driven by multiple expansion—yes, even through that quick bear market, which saw a rapid multiple compression only to be followed by an even more incredible multiple expansion.  The chart below decomposes the annual returns for the S&P 500 and TSX comprising dividends, earnings growth, and change in the multiple. The light blue bars show changes in the market multiple, by far the biggest driver of index performance in the past two years. Please note, while earnings and dividends grow over time, the market multiple does not grow, it is a zero-sum game.  In other words, multiple expansions are offset by multiple contractions in other years.

2019 to 2020 S&P 500 Return Decomposition and TSX Comp Return Decomposition

Get the latest market insights to your inbox each week from Craig Basinger.

We have started to see some multiple contraction after a few years of expansion in 2021. The good news is earnings growth came to the market’s rescue, big time.  The forward 12-month consensus earnings for the S&P 500 was $166 at the start of 2021; it is now $214 for the next 12 months. Earnings initially were just rebounding off depressed levels but over the past few quarters it has been the stronger-than-anticipated economic recovery that has driven estimates even higher. And rising earnings cure or sooth many market ailments. Higher yields, Fed tapering, China real estate issues…if there is enough earnings growth, the market won’t care nearly as much.

Okay, so why are we going on about earnings?

Earnings growth, or more accurately, rising earnings forward estimates, have driven market returns in 2021 (the EPS growth bars in the previous chart). Re-opening economies, higher commodity prices, and surprisingly robust demand growth focused on durables over services created the perfect elixir for S&P and TSX earnings. A 29% rise in forward earnings from nine months ago is the fastest pace we have seen in a long time. TSX at 24% is no slouch either. BUT, over the past few weeks we have started to see earnings estimates begin to fall. Don’t get too alarmed, this isn’t earnings growth turning negative, estimates are just falling. Currently, the S&P 500 is expected to earn $198.62 for 2021 (two quarters in the bag, two to go). And next year, bottom-up consensus estimates are for $218.03, which is clearly positive, albeit a slower pace of earnings growth (+10%).

These estimates have started to decline, reversing a trend in rising estimate revisions. For the past year, the trend in estimate forecasts has been in the upward direction, but in mid-August, this trend stalled and September has witnessed analysts revising their earnings forecasts lower (see the chart below). While it’s still a subtle decline, the new direction is not encouraging.

July 1, 2021 to September 16, 2021 S&P 500 earnings' estimation

Some slowing of the momentum in economic growth is one factor. However, another is rising costs.  Last week saw Fedex Corp, often a bellwether for economic activity, highlight that while demand and pricing remain healthy, costs are now rising faster and offsetting the good news. Shares fell 8% on the news.

Digging deeper into Q3 earnings, which will start to be reported early in October, the negative revisions appear most prevalent in a few sectors with consumer discretionary taking the brunt of the revisions.  A couple factors contributing to this include autos, which are experiencing supply chain disruptions. Plus, as the economy re-opens and consumers begin spending more on services, a side effect of this is spending less on durables (a big component of consumer discretionary).  Industrials have seen the second-largest decline in estimates, and this will likely expand as analysts update their forecasts from the Fedex lowering of guidance.

S&P 500 Sector Q3 earnings revisions from peak

There is a silver lining to these U.S. trends in sector earnings revisions for Q3. The TSX, given its heavier weighting in energy, materials, and financials, should be less impacted, assuming the sector trends are evident across the border.  And in fact, this is what the numbers show as well.  Estimate revisions for the TSX Q3 earnings season have not seen the same negative revision pace as the U.S. market. Go Canada.

Investment Implications

Earnings growth and positive revisions have helped equity markets move higher over the past year.  Unfortunately, that positive impulse appears to be fading. While the negative revisions are minor so far and there is still positive earnings growth, this coming Q3 earnings season may not be a cake walk. The past earnings season have witnessed much higher than normal positive surprise rates in terms of the frequency of companies exceeding estimates and the magnitude of those ‘beats.’ As costs continue to rise and the pace of top line sales growth slows, companies better able to control costs and/or pass costs onto customers should fair better.

Added consideration should be given to holdings or exposure to consumer discretionary, industrials and consumer staples. Estimates in these sectors are being revised lower for good reason. Having less exposure or tilting towards more defensive holdings in these sectors may prove prudent as we begin to navigate through more challenging earnings seasons.

— Craig Basinger is the Chief Market Strategist at Purpose Investments


Sources: Charts are sourced to Bloomberg L.P.

The content of this document is for informational purposes only, and is not being provided in the context of an offering of any securities described herein, nor is it a recommendation or solicitation to buy, hold or sell any security. The information is not investment advice, nor is it tailored to the needs or circumstances of any investor. Information contained in this document is not, and under no circumstances is it to be construed as, an offering memorandum, prospectus, advertisement or public offering of securities. No securities commission or similar regulatory authority has reviewed this document and any representation to the contrary is an offence. Information contained in this document is believed to be accurate and reliable, however, we cannot guarantee that it is complete or current at all times. The information provided is subject to change without notice.

Commissions, trailing commissions, management fees and expenses all may be associated with investment funds. Please read the prospectus before investing. If the securities are purchased or sold on a stock exchange, you may pay more or receive less than the current net asset value. Investment funds are not guaranteed, their values change frequently and past performance may not be repeated. Certain statements in this document are forward-looking. Forward-looking statements (“FLS”) are statements that are predictive in nature, depend on or refer to future events or conditions, or that include words such as “may,” “will,” “should,” “could,” “expect,” “anticipate,” intend,” “plan,” “believe,” “estimate” or other similar expressions. Statements that look forward in time or include anything other than historical information are subject to risks and uncertainties, and actual results, actions or events could differ materially from those set forth in the FLS. FLS are not guarantees of future performance and are by their nature based on numerous assumptions. Although the FLS contained in this document are based upon what Purpose Investments and the portfolio manager believe to be reasonable assumptions, Purpose Investments and the portfolio manager cannot assure that actual results will be consistent with these FLS. The reader is cautioned to consider the FLS carefully and not to place undue reliance on the FLS. Unless required by applicable law, it is not undertaken, and specifically disclaimed, that there is any intention or obligation to update or revise FLS, whether as a result of new information, future events or otherwise.