Friendly Reminder: Stocks Are Forward-Looking

Befitting the month of August, Monday was an overall slow news day in the financial realm, leaving headlines with the unenviable task of trying to get you to care about very small things. Most of these items aren’t significant enough to warrant full commentary here, but we did notice a common refrain worth discussing: But earnings are great. High-frequency and real-time economic indicators show the recovery is losing steam—but Q2 earnings were great, so be bullish. COVID cases are spiking—but Q2 earnings. The delta variant is in China—but Q2 earnings. Oil and commodities markets may be pointing to weakening economic growth—but the earnings! Look, we like the overall good cheer, and we are bullish! But Q2 earnings results are not a valid reason for that, in our view.

Since we highlighted S&P 500 earnings growth last week, the estimated growth rate has inched up to 89.0% y/y, and the ability to round that to 90% seems to be generating today’s earnings-related bullishness.^[i] Whether you round up or not, Q2’s earnings growth rate is marvelous—that we don’t dispute. But the logic in using it to justify bullishness now doesn’t hold up.

Q2 earnings reports, in case the name didn’t make it obvious, cover April, May and June 2021—and how those compare to the same three months in 2020. Today is August 9, nearly a month and a half after Q2 ended. Those allegedly creeping negatives are happening now. They will show up in Q3 and maybe Q4 earnings. You can’t use corporate profitability in Spring 2021 to debunk fears about autumn and winter.

We see this mistake over and over again, in write-ups on daily market movement as well as the aforementioned chronological confusion. People presume earnings results must be significant to stocks on the date of their announcement. But any visible impact is temporary and sentiment-related at most. Stocks just aren’t that myopic. They look about 3 – 30 months ahead, pricing in expected events. Rip-roaring Q2 earnings growth was one of the most widely expected events in recent memory, due to the thunderingly obvious confluence of weak year-over-year benchmarks and the reopening boomlet. Stocks saw that coming a mile away and quickly priced it, probably well before Q2 even started.

In our view, stocks didn’t close at all-time highs on Friday and hover around there on Monday because companies were hugely profitable a few months ago. Rather, they are still doing what they do best: Looking forward and registering the likely future. In our view, the continued ascent is stocks’ way of telling us they have seen the future and it is not a delta-variant nightmare. They likely see society is increasingly good at living with this virus and, outside Australia and New Zealand, facing it without forcing entire economies to close. They realize COVID flareups here and abroad were always probable. They understand growth was virtually assured to slow after the initial burst of pent-up demand wore off and long-running economic trends reasserted themselves. They weighed cooling demand for restaurant reservations and movie tickets—and don’t see it as a harbinger of economic doom.

There is one aspect of Q2’s earnings reports that we do think is meaningful looking forward: gross profit margins, which are presently at 32.6% for the S&P 500 and 29.7% for the MSCI World Index.^[ii] That doesn’t predict stock returns. But it does show companies have a lot of bandwidth to absorb higher costs and slowing demand while remaining quite profitable—a good reason to be optimistic now, in our view.

We also think this is reason to be optimistic about growth stocks specifically, as those usually have the biggest gross margins and are best-positioned to weather slow-growth stretches. When markets anticipate slower growth, they reward the companies that don’t depend on economic acceleration. Growth stocks tend to capitalize on long-term trends, not the economic cycle. Their fat gross margins are a nice cushion against temporary hiccups, whether from the delta variant, supply shortages, rising raw materials costs or whatever other short-term speedbumps inevitably steal headlines. Not coincidentally, they have led value by a mile since mid-May (and, cumulatively, since the bull market began in March 2020).

So don’t look backward. Think like markets, look forward, and leave Q2 earnings growth out of the equation. If stocks have already moved on from it, then you should too.