The Earnings Slump Seems Over

So much for contraction. With 410 S&P 500 companies reporting Q4 results as of today, profits grew for the first time since 2019. That is a huge turnabout from the continued decline analysts expected. That earnings beat expectations, in and of itself, isn’t anything earth shattering. It happens much more often than not. But in this environment, it is more noteworthy. Sentiment has improved markedly in recent months, and as it did, analysts revised their Q4 earnings expectations higher. That reality still beat those higher benchmarks is, in our view, a good sign sentiment isn’t yet irrationally high.

The S&P 500’s Q4 blended earnings—combining reported results with remaining consensus expectations—are now up 3.0% y/y.^[i] If this holds through the rest of reporting, it will snap a three-quarter string of year-over-year contractions and blow away analysts’ -9.3% y/y consensus estimate at last year’s end. About 80% of companies reporting beat analysts’ earnings and revenue growth estimates—both well above average historically.^[ii] That is even more remarkable considering analysts ratcheted up their expectations as sentiment improved last autumn. In September, they anticipated a -13% y/y drop in Q4 earnings.^[iii] With vaccinations rolling out in the new year and sentiment riding high, analyst consensus had cut this in half. By mid-January, with only 26 companies reporting, the consensus saw a much milder -7% y/y earnings contraction. Instead, profits are up, illustrating the unexpected speed with which Corporate America has climbed out of its deep lockdown-induced hole.

In a typical expansion, it isn’t unusual for earnings to return to growth less than a year after a bear market ends. But a big chunk of that early growth usually comes from cost cuts. Firms get lean and mean during a recession and keep trimming the fat early in a recovery, hoping to drive growth through productivity gains. Favorable year-over-year comparisons also help if the recession drags on for a while. For example, after the global financial crisis, S&P 500 earnings returned to growth in Q4 2009. Their growth rate, thanks to a depressed comparison, topped 100%.^[iv] But revenues grew just 5.8% y/y off their own depressed comparison.^[v]

This time, neither of those explanations apply. Earnings growth didn’t come from an easy comparison—they grew above Q4 2019’s pre-pandemic level. Cost cuts alone don’t deserve the credit, either. Blended Q4 revenue for the S&P 500 also grew 3.0% y/y, matching earnings growth.^[vi] This is one more way in which last year’s lockdown-driven downturn doesn’t look like a typical recession. Nor did year-over-year gains come solely from COVID winners. 248 of 410 companies (60%) reported positive earnings growth, while 243 companies’ sales (59%) rose. Overall, 9 of 11 sectors’ profits are higher, with revenues up in 8.

One of those sectors that didn’t grow: Energy, which deserves a closer look. Although it had the worst Q4 results by far, its stocks are the best performing this year. With just over half of the sector reporting, Energy’s Q4 earnings are down -110% y/y.^[vii] That might not seem mathematically possible. But in Q4 2019, the sector’s net income was $11.5 billion. In Q4 2020, with 13 of 25 companies reporting, it was -$1.2 billion—the only sector to report a loss. Yet the S&P 500’s Energy sector is up 22.8% this year.^[viii]

In our view, the apparent divergence between the results rolling in and Energy’s performance shows how markets work: They look forward. Energy earnings are sensitive to oil prices, which are up 26.5% year to date after declining -20.9% last year.^[ix] We don’t think it is a coincidence analysts have revised Energy’s full-year 2021 earnings estimate up 27.3% from Q4’s end.^[x] Markets have seen this and incorporated it into Energy stock prices rather than dwelling on the past. They already dealt with last year’s problems, when the sector fell -33.7%.^[xi]

This also illustrates why jumping on the Energy bandwagon now likely isn’t the most beneficial move. Oil’s rebound and its potentially positive impact on earnings are widely known. Looking forward over the next couple years, investors should ask: Is there much more unpriced upside in oil? Beyond the recent cold-snap induced hiccup taking more than a quarter of daily US oil production offline temporarily, global production seems set to rise sharply this year and into next.^[xii] With supply responding to higher prices, Energy’s run may prove shorter than the current enthusiasm suggests.^[xiii]

As for the broader market, the latest 2021 estimates put S&P 500 earnings 6.6% above 2019’s peak, which doesn’t seem unreasonable to us.^[xiv] It could even prove low, depending on the pace of vaccination and reopening. Rising revenues show how firm demand is. The more the country and world reopens, the more of an outlet that demand will have.