Our Guidance for Q1 2020's Earnings Season

For the past several weeks, stocks have been pricing in the near certainty that COVID-19 containment measures will drive recession and hammer corporate earnings. Yet the precise extent of the damage remains a mystery, even with consensus expectations for Q1 earnings tumbling from 2.1% year-over-year growth two months ago to a -10% year-over-year decline at last week’s end.^[i] This week we will finally begin getting more clarity, with Q1 earnings season kicking off in earnest. Brace yourself now for some truly awful numbers, and keep two things in mind. One, stocks have been laser-focused on this and are highly unlikely to be surprised by bad news. Two, just getting the numbers will reduce uncertainty a bit and help investors and analysts form more educated expectations for Q2 and beyond.

Considering how much life has changed since the lockdowns began in America and Europe, a -10% slide from Q1 2019’s earnings might seem rather mild. But most of the business closures and shelter-in-place orders didn’t take effect in America until about halfway through March. It wasn’t quite business as usual before then, considering China’s lockdowns disrupted supply chains in January and February, hurting American businesses reliant on those imports. But the worst came late in the quarter. That is why expectations for Q2 earnings are even worse, presently at -20% y/y.^[ii]

Expect that number to shift quite a bit as Q1 results come in. Never before have we endured such a widespread shutdown of the private economy. The unprecedented nature makes analysts’ models mostly guesswork at this point. But getting Q1 results gives them a baseline to recalibrate. They will have actual numbers to weigh. That helps them assess not just the extent of the damage thus far, but how the numbers might evolve from here depending on how long closures last. Not that any of these models will be perfectly accurate—all forecasts are opinions—but the more flow charts we get showing how earnings might differ if normal life resumes in May, June, July or what have you, the more markets can adjust expectations.

This is key at a time when nearly 300 companies have withdrawn their full-year earnings guidance, according to a Wall Street Journal analysis.^[iii] This has led many to fear stocks are flying blind, unable to accurately price earnings over the rest of the year and beyond. Yet companies’ earnings guidance is only one input to the market’s expectations, and it isn’t exactly an airtight prediction. It is a fine thing, don’t get us wrong. But markets are more than capable of formulating their own conclusions without guidance. In some ways, we also think guidance is something of a marketing exercise. We (and many other market participants) suspect companies often use it to influence expectations, usually to the downside, in order to tee up favorable coverage for beating expectations later. Markets know this, which is why they usually see through the whole exercise.

Companies’ inability to issue full-year guidance right now also underscores one of our long-running points about this bear market: The disruptions’ length matters more than the magnitude of the contraction in the near term. Companies can’t make reasonable estimates for full-year earnings until they know how long they will have to be shut. If life starts getting back to normal in May, it could tee up a strong Q3 rebound, and full-year earnings might beat the -8.5% decline that analysts presently have penciled in.^[iv] If we are all still in this dismal boat at mid-summer, full-year results could be far worse. The single greatest point of clarity we can get is a schedule for the country getting back to work.

Note, markets probably won’t wait for this clarity, just as they didn’t wait to start pricing in the near-term damage. Bear markets don’t typically end when the economy starts improving. They end when expectations become too detached from reality on the negative side. With that in mind, one of the most encouraging things we could see these next few weeks would be extremely pessimistic earnings coverage, with dire warnings of how much worse it will get in Q2 and beyond. The more of this we see, the lower the bar becomes for reality to clear. A lack of guidance from major companies may actually facilitate expectations overshooting to the downside.

So as the results roll in, we encourage you to avoid getting too caught up in the circus. What happened in Q1, however bad, likely isn’t news to stocks. Handwringing over the future, rather than being predictive, should just help solidify sentiment. In our view, stocks move most on the gap between expectations and reality not for today or tomorrow, but the next 3 – 30 months. For the past few weeks, they have focused on the short end of that window. The more that affects sentiment, the easier expectations for the long end should be to beat.