We’re going to dedicate today’s “Data” section entirely to US large cap corporate earnings for four reasons:
- First, with Q3 reports largely in the bag we have a solid baseline to consider.
- Second, the upside in US corporate earnings this year is entirely responsible for the S&P 500’s YTD gains (23 pct better than expected at the start of the year, 25 pct S&P price return to date).
- Third, this surge in US corporate earnings underpins everything from strong corporate debt markets to global equity returns. US equities represent more than half (60 pct) of the total value of worldwide stock markets and give rest-of-world stocks a very large valuation umbrella.
- Lastly, at current valuations – 21.1x estimates for 2022 earnings – there is no room for error when it comes to evaluating future earnings power.
At first blush, it would seem easy to say that Wall Street earnings expectations remain too low and US large cap earnings power is still not fully baked into stock prices. The chart below shows why. We are coming off a record quarter for S&P 500 earnings with Q3’s $53.60/share. Going into the quarter’s reporting season the Street was at $48.89/share. That was lower than Q2’s actual $49.02/share. Analysts thought there was no way the S&P could out earn Q2, but they were wrong – and badly so.
As you can see from our notes on this chart, we are in the same position again going into Q4 2021. Wall Street analysts think Q4 and Q1 2022 will show lower earnings than Q3 actuals ($51.00/share and $52.02/share, respectively, versus $53.60/share). That seems overly pessimistic given continued economic growth and the now-proven ability of US companies to offset input cost inflation with pricing power of their own.
Now, here’s the other side of the coin: sequential Q3 – Q4 net margins are notoriously hard to predict. The FactSet chart below, with our annotations, tells that story. Analysts expect margins to drop by 1.1 points from Q3 to Q4 2021 (noted in red). The worst margin contraction in the last 4 years was in 2018 (0.8 points) and that was due to the sudden slowing of the US economy from the Fed’s ill-considered cycle of rate increases. In 2017 and 2020, margins held up from Q3 to Q4. In 2019, they fell by 0.6 points.
Given this difficulty in calling sequential margin structure, one can excuse Wall Street’s analysts’ cautious stance on Q4 and Q1 2022 S&P earnings. Better to guess low and be surprised than go out on a limb and be disappointed.
Our own take is that Q4 2021 will be substantially better than analysts’ expectations because:
- We strongly suspect many companies have been over-accruing expenses this year as they report quarterly earnings. That was an entirely reasonable thing to do given 2021’s manifold uncertainties. However, as companies true up their books and consider accrual rates for 2022, Q4 should see a bump in margins and therefore reported earnings.
- US and global economic growth should remain more than robust enough to allow companies to hold margins close to 13 percent (the average of the last 2 quarters). Let’s remember that Q3 US GDP growth was just 2.0 percent and margins remained strong at 12.9 percent. Expectations for Q4 GDP are running at 4 percent just now. This is not, in other words, 2018 all over again.
- Given everything that has happened in the last 12 months, the companies of the S&P 500 deserve some benefit of the doubt on the related issues of sustainable margins and corporate earnings. Inflation … Labor shortages … Supply chain issues … And yet the S&P 500 has just printed a record quarter for earnings per share. An all-time record …
We’ll close out with what we always call “the most important chart for stock investors” – FactSet’s 2021 and 2022 aggregate Wall Street analysts’ S&P 500 earnings estimates. It is a remarkable image. In most years, these lines would be trending the other way. Analysts always put out estimates that are a touch too high, cut them slightly ahead of a quarter, let the company “beat” that number, and repeat the whole process again in 90 days’ time.
Not this year. Estimates for 2021 have gone up almost each and every week in 2021. Estimates for 2022, some recent squirreliness aside, are following the same pattern. And all this is happening against a backdrop of record highs for S&P 500 EPS, some 26 percent higher than 2019’s pre-pandemic level.
Takeaway: we’ve been hammering away on this topic a lot recently, so we’ll likely leave it alone for the rest of the week, but it remains the single most important capital markets issue out there. We don’t care if the Fed raises rates 4 times next year and 10-year Treasuries end up yielding 3.0 percent. If S&P earnings end up at +$240/share in 2022 (i.e., 10 pct above current estimates), none of that will likely matter much to stock prices. Just look at this year for proof that earnings can trump pretty much anything else.