The Super Investor

Earnings Recovery

Marcus Tuck
Head of Research

7 am February 23, 2021

Signs of an earnings recovery are becoming clearer at home and abroad. Furthermore, the recovery in earnings is still in the early stages and is expected to extend through this year and next.

In the US, where 83% of S&P 500 companies have already reported their results for Q4 2020, 79% of companies have reported a positive EPS surprise and 77% have reported a positive revenue surprise. Both percentages are well above average.

The sectors delivering the most positive earnings surprises can be seen in the chart below. The Communication Services (95%), Information Technology (90%) and Financials (81%) sectors have the highest percentages of companies reporting earnings above forecasts.

US profits beating forecasts

Source: FactSet

The magnitude of the earnings beats is impressive too. In aggregate, companies are reporting earnings that are 14.6% above expectations, more than double the 5-year average of +6.3%.

For Q4 2020 the blended year-on-year earnings growth rate for the S&P 500 is 3.2%, which marks the first positive year-on-year growth rate since Q4 2019. Revenue is now 3.0% higher than a year ago.

This is just the start of the earnings recovery. Looking at future quarters, analysts forecast double-digit earnings growth for all four quarters of 2021, with year-on-year earnings growth peaking in Q2 2021 at 49.5%.

The trend can be more easily seen by focussing on the earnings forecasts for calendar years 2021 and 2022.

After declining by an estimated 11% in 2020, the aggregate earnings per share (EPS) of S&P 500 companies is forecast to rise by about 24% in 2021, led by the cyclical sectors Energy, Industrials, Consumer Discretionary and Materials (see chart below).

US earnings outlook for 2021

Source: FactSet

The reason no bar is shown for the Energy sector is because the sector is moving from a net loss position in 2020 to net profit in 2021 following a recovery in the oil price. The WTI oil price has risen from briefly negative in April 2020 to around US$60 a barrel now.

The US earnings recovery is expected to extend into 2022 as well, but with the growth rate moderating as the negative quarters drop off the comparison period. Overall, S&P 500 earnings are expected to grow by 15.5% in 2022 (see chart below).

US earnings outlook for 2022

Source: FactSet

Things that are likely to prolong the economic and earnings recoveries in the US are President Biden’s proposed US$1.9 trillion fiscal stimulus package (nearly 9% of US GDP), a continuation of the Federal Reserve’s loose monetary policy, and the roll out of COVID vaccines.

Australian earnings outlook improving

Australia’s reporting season still has another week to go but so far has been generally meeting or exceeding expectations for companies outside of travel-related industries. Retailers, especially those with a strong online presence, have been a standout. The mining outlook is generally positive. Bank results are improving with impairment charges rolling off quicker than expected. The dividend outlook is improving, with aggregate dividends already increasing, and corporate balance sheets are generally in good shape. The ground work has been laid for a domestic earnings recovery in FY21 and FY22.

Market risks

As we pointed out in our last market update, the main risk is coming from a rising bond yield. Even though central banks will keep short term interest rates low for a long time, longer term bond yields are rising as the market becomes more convinced about economic recovery and the risk of rising inflation [given the magnitude of President Biden’s proposed spending program].

The US 10 year bond yield has continued to rise since our last report, but at 1.38% it is still low by historical standards. The following chart shows the 50 year history of the US 10 year bond yield.

Source: Trading Economics

The rising bond yield is being offset by the earnings recovery, but if the bond yield was to rise above 2.5% it would pressure equity valuations more heavily.

A good way to look at it is by calculating the equity risk premium (ERP). The current 12 months forward P/E ratio for the S&P 500 is 22.1 based on the latest FactSet data. That equates to a 12 months forward earnings yield of 4.5%, which, after subtracting the current bond yield, gives an ERP of 3.1%.

Historically, whenever the US ERP has fallen below 3% the equity market becomes more prone to valuation-related pullbacks. A sub-2% ERP is particularly dangerous. In that situation, investors are not being sufficiently rewarded for accepting the increased risks associated with equities compared to bonds.

In Australia’s case, our share market gets extra yield support from the fact that our dividend yield is much higher than the Australian 10 year government bond yield of 1.6%, particularly after including the benefits of dividend imputation.

With aggregate dividends now increasing in Australia, and the RBA not expecting to increase the cash rate “until 2024 at the earliest” [based on its latest statement], the Australian share market will continue to attract considerable yield-based buying support.

Disclosure: Nil.


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