We’ll focus today’s Data section on just one topic: why are Wall Street analysts reducing their Q3 US corporate earnings expectations and what does that mean for equity prices? Here is the setup for the discussion:
- We are laser-focused on this issue because of the strong and logical year-to-date correlation between 2021 whole-year earnings expectations and S&P 500 performance.
- The former is up 20 percent year-to-date ($167/share at the start of the year, $201/share now). The latter is up 18 percent YTD, and with less volatility than one might expect given pandemic-related global economic uncertainty.
- In a typical year, earnings expectations actually decline because analysts typically overestimate current year results. This was not notably the case in 2021, and that has provided US large caps with a powerful year-long tailwind.
Three points on this:
#1: As the following FactSet chart shows, analysts have been consistently increasing their Q3 2021 earnings estimates for much of the last 12 months. The solid dark blue line goes up and to the right in fairly consistent fashion from $43.20/share in S&P 500 expected earnings for Q3 2021 in September 2020 to $49.20 today. The light blue line is the S&P 500, which tracks these revisions.
But, zero in on the far-right side of the chart, and you’ll see analysts have at the margin been cutting their Q3 estimates over the last 2 weeks. The numbers:
- Week ending September 3rd: $49.30/share for Q3 S&P 500 expected earnings
- Week ending September 10th: $49.23/share
- Week ending September 17th: $49.11/share
Takeaway: while the net reduction may seem small (a cut of 0.4 percent over the last 2 weeks), it stands in stark contrast to a year’s worth of upward revisions. Markets know even small cuts to estimates can be important, and we see this fact as contributing to September’s month-to-date weakness.
#2: Now, let’s review which S&P sectors are seeing the brunt of the estimate cuts. S&P Sectors with notable negative estimate revisions in the last 2 weeks:
- Industrials: were expected to show a +73.6 percent increase from Q3 2020 two weeks ago. Now that expected comp is +68.1 pct, lower by 5.5 percentage points.
- Consumer Discretionary: +4.9 percent growth expected 2 weeks ago, +3.1 pct now (1.8 points lower).
- Materials: +92.1 percent growth over Q2 2020 expected two weeks ago, +91.0 pct now (1.1 points lower).
- Financials: +18.2 percent growth expected two weeks ago, +17.8 pct now (0.4 points lower).
That’s about it in terms of industry groups where analysts have been cutting Q3 estimates. The other 7 sectors of the S&P 500 have seen either very small negative revisions (Communication Services, Health Care, Consumer Staples) or expectations remain the same/slightly higher (Tech, Energy, Utilities, Real Estate.
Takeaway: the US economy has slowed during Q3, so it’s logical that Wall Street analysts would trim their estimates for cyclical groups as a result. That, however, is not necessarily a bad sign if their starting points (estimates from 2 weeks ago) were too low. Which leads us to our final point …
#3: As unwelcomed as seeing S&P 500 Q3 estimates go from $49.30/share to $49.11/share over the last 2 weeks is, we’ll come back to the same point we’ve been making all quarter: why should the S&P earn less in Q3 than Q2’s $52.80/share?
One valid reason would be if the US economy is shrinking, but that’s not the case. The Atlanta Fed’s GDPNow model is looking for +3.6 pct growth this quarter, for example. Job growth has been positive, and last week’s strong Retail Sales report confirms Q3 GDP growth is above zero.
Earnings seasonality could be another factor; perhaps Q3 typically shows a decline from Q2, but historical operating earnings data during economic expansions shows that’s not true:
- From 2010 – 2019, Q3 S&P 500 operating earnings per share were on average +2.0 percent higher than the immediately preceding Q2.
- From 2001 – 2006, the average sequential change in Q2 – Q3 earnings was +2.8 pct.
- From 1991 – 1999, Q3 S&P EPS was on average essentially the same as Q2 (+0.2 pct).
So, if there’s no stealth recession going on and Q3 is typically as least as good as Q2, then why are Wall Street analysts estimating the Q3 2021 EPS will be lower than Q2, as this FactSet chart shows they are predicting? The simple answer is conservatism, both on the part of analysts and the companies they cover. The more complex one is margin compression due to factors like input cost inflation, higher labor costs, and logistics challenges in cyclical groups, as we outlined in point #2 above.
Takeaway: if the Street is right and $49/share is the correct number for S&P 500 Q3 earnings, then US large caps are a raging short right here. There’s simply no way a market that trades for 20x 2022 estimates ($220/share, with 2021 at $201/share) is expecting Q3 results to be down 7 percent from Q2. Such an outcome would strongly imply that there’s no way we’ll get 10 percent earnings growth in 2022, after all.
Concluding thought: it was much easier to be bullish on US stocks when analysts were raising estimates virtually every week, as they did up until this month. Now, we must rely on the commonsense approach of sequential quarterly earnings comparisons and swim against the tide of Wall Street earnings revisions. Q3 financial reporting season is still 4 weeks away, however. Until then, we believe US large caps will continue to struggle.
FactSet Earnings Insight report: https://www.factset.com/hubfs/Website/Resources%20Section/Research%20Desk/Earnings%20Insight/EarningsInsight_091721.pdf