Earnings Reality Is Beating Expectations—by a Lot

With 92% of S&P 500 companies reporting Q3 earnings, the results are not only much better than what analysts anticipated at midyear—during the lockdowns’ depths—but even better than expectations set as the world reopened somewhat in the fall.^[i] While mostly backward looking, the yawning gap between reality and expectations suggests stocks still have plenty of room to keep climbing the wall of worry.

Entering earnings season, analysts expected a bloodbath. But the results weren’t nearly as awful as expected. At their worst—halfway through 2020—analysts expected Q3 earnings to plunge -25.4% y/y and sales to drop -5.6%.^[ii] As Q3 closed, they had revised those estimates up a smidge to -21.1% y/y and -3.6%, respectively.^[iii] But now, with most results in, companies are smashing those initial projections. Q3 earnings are on track to fall just -7.1% y/y, with revenues only -1.6% below Q3 2019.^[iv]

Better-than-expected results are widespread and historically above average. Of the companies that have reported so far, 84% surprised positively—a record high and well above the 73% five-year average.^[v] Further, Q3 earnings have topped estimates by a whopping 19.4%—second only to Q2’s 23.1% and way above the 5.6% five-year average.^[vi] In short, last quarter’s earnings reveal a big reality-expectations gap.

The latest earnings reports also debunk pundits’ claims that only narrow market segments are driving growth and returns. All 11 sectors are exceeding estimates—it isn’t just a handful of Internet behemoths beating expectations. Moreover, four sectors—Health Care, Staples, Tech and Communication Services—have grown earnings and revenue year-over-year in Q3. They comprise 60% of the S&P 500’s market value.^[vii] Yes, these are COVID winners, but that doesn’t mean their strength is temporary. These sectors typify growth-oriented stocks, whose underlying drivers usually don’t depend as much on the economic cycle.

Of course, not all sectors are this strong. Energy and Industrials, namely, have dragged down Q3’s results, mitigating the biggest sectors’ gains. This isn’t exactly surprising, with lockdowns disproportionately affecting transportation and associated fuel demand. Energy earnings cratered -109.1% y/y in Q3 (slightly better than the -111.4% expected at quarter-end), while Industrials’ earnings almost halved -49.3% (versus the -61.5% expected in September).^[viii] This was with double-digit revenue declines of -34.8% y/y and -15.2%, respectively.^[ix] But this doesn’t tell the full story. Airlines fall under Industrials, and their earnings nosedived -313.0% y/y, contributing to about half of the S&P 500’s earnings decline.^[x] Other groups within Industrials fared better, underscoring the importance of digging below the surface. For example, air freight and logistics companies’ earnings soared 27.2% y/y—an underappreciated sign of how burgeoning e-commerce doesn’t benefit certain famous online shopping giants alone.^[xi]

With vaccines in the wing, some say growth leadership will fade in favor of value-oriented stocks, like within Energy, Industrials and Financials, but we think this is premature. Such economically sensitive sectors have lagged greatly this year—and over the last decade. However, after recent promising vaccine results, many suspect economically sensitive value stocks are set to lead with their month-to-date edge only the beginning. While possible, we don’t presently see this as probable. The interest rate environment doesn’t support Financials’ profits or a big credit boost to aid typically leveraged value firms. Energy is still dealing with a supply glut that doesn’t seem set to abate soon. Their recent outperformance looks like another sentiment-based countertrend to us. In our view, a prolonged leadership shift requires an underappreciated shift to fundamentals. Vaccine developments are noteworthy, but not underappreciated, and they don’t affect all fundamentals driving value.

Looking ahead, analysts are penciling in further earnings and sales improvements. Currently, they expect Q4 earnings to fall -10.8% y/y, but they anticipate revenues slipping only -0.2%.^[xii] That seems pretty good to us, considering Q4 2019 was economic activity’s pre-COVID peak.^[xiii] If revenues turn out to be just a rounding error below that, despite this quarter’s stalled reopenings and renewed shutdowns, we would take that as a good sign of the economy’s underlying strength. Sales’ rebound to near last year’s peak levels—albeit only for publicly traded companies—would be a great testament to Corporate America’s resilience after the record deep quarterly GDP contraction seen in Q2.

Stocks, though, are likely looking further into the future. For full-year 2021, analysts’ estimates call for a 22.1% y/y rise in earnings on 7.8% revenue growth.^[xiv] Now, we aren’t saying this is some huge increase. It would be off a low 2020 base. If S&P 500 earnings rise 22.1% next year, they would be up just about 3% from 2019’s high.^[xv] But we think it does help provide a general, bigger-picture guide for how stocks are fathoming a time in the next few years when COVID fades and lockdowns are a memory.

Past earnings don’t tell you where profits—or stocks—will head. But we think the story of how reality has related to expectations on the profit front explains a whole lot about how this young bull market has evolved.