Stock prices tend to follow earnings trends

One of the principle adages around stock markets and stock prices is that they follow the long-term earnings (or profitability) trends of businesses. Over short periods of time, prices are typically affected by expectations for profits and/or cash flows. When earnings and cash flows are expected to rise, stock prices tend to reflect that expectation by moving higher. When they’re expected to slow, (or even decline as was seen in the 2nd quarter of 2020), stock prices would be expected to follow suit. This can generally also be seen over long time periods, however, when we see big variations over shorter time periods we would expect distortions and heightened market volatility. Given the instability of profits over the last year and a half, the estimation of what a fair value for the markets is has been made much more difficult.

Earnings results for Q2 2021

As we approach September, we are concluding the reporting season for corporate profitability for the 2nd calendar quarter of the year. Typically, earnings results are judged on the basis of how they compared to consensus analyst’s expectations. This year’s reports are all the more interesting from the standpoint of what occurred in the 2nd quarter of last year. They provide a view of not only how businesses are recovering generally on a sequential basis, but importantly, also a view on a year-over-year basis from the depths of the pandemic and the shutdown.

As of the time of this writing, about 92% of S&P 500 companies have reported 2nd quarter results. In general, companies have exceeded the consensus analyst’s expectations by a substantial margin. According to FactSet, 87% of companies have reported earnings above the estimates, which is above the five-year average of 75%. In aggregate, companies are reporting earnings that are 17.1% above estimates[1]. On a year-over-year basis, it is estimated that once all companies have reported, earnings will have increased about 89%, and be the highest year-over-year increase since Q4 2009. This is all positive news for markets, but as mentioned above, markets are influenced in the short-term by expectations for the future rather than results of the past. One might argue that these results were largely priced into stocks well before the actual results were released. Given that the 2nd quarter ended a couple months ago, it begs the question… where might we see profits going in the future?

Outlook for the remainder of 2021

Looking ahead, the consensus estimate has earnings growing about 20% in both the 3rd and 4th quarters of this year. If true, this could serve to put a firm floor under current market levels and provide the launch pad for future advances. This does not however indicate that stock prices can be expected to increase by this factor in the coming months.

There are risks. Not the least of these is that the major stock indices are currently trading at elevated levels from their historical averages, when considering metrics such as the traditional price/earnings (p/e) ratio. For this reason, it may take some time for earnings to “catch up” with current market levels. There is quite a bit of debate on this topic… as p/e’s, for some very large companies that tend to dominate the indices are elevated, while other smaller companies continue to hold closer to their historical levels. Time will tell whether or not we’re in a new environment with respect to the accepted levels of some valuation measures. To be sure, a lot of things have changed in the past year that might affect this.

Another risk is the fear that we may actually have already seen the peak of economic growth from the recovery – both here and abroad. As recently as a few months ago, there was widespread optimism for an extended recovery phase for the economy as we exited the pandemic. But, with the surge in the Delta variant, and the threat it holds to slow economic recovery, things may play out differently. Add to this the impact of China’s crackdown on large domestic companies, and the pace of global economic growth could be disappointing going forward.

We are continually monitoring these issues and revising our outlook accordingly. That said, we are comfortable with the positions and allocations in our client’s strategies, and will make adjustments as we deem warranted for the future.

Bonds and rates

This year has been nothing if not dramatic in the bond markets. Since January 1, we’ve seen the benchmark 10-year U.S. Treasury yield move from 0.93% to a high of 1.74% on March 19, back down to 1.19% at the beginning of August, and back up to 1.36% as of August 12[2]. Expectations for economic growth and inflation (the two primary drivers of interest rates) have been volatile, and with those… have gone rates. We believe that while rates may move moderately higher in the coming year, we will remain in a comparatively low rate environment for years to come.

As for credit, we have seen spreads (the additional yield available in a riskier bond investment as compared with a “risk-free” investment such as U.S. Treasury bonds) coming down for some time. We see spreads at quite a bit below their long-term averages, indicating that investors are willing to take on the additional risk in lower grade credits in exchange for nominally higher yields. As we view the bond market as more prescient than the equity market in its’ collective wisdom about the future, we interpret this as a positive indicator.

Where do we go from here?

We think that corporate profit growth will remain attractive into 2022. While challenges will be present in dealing with the virus and prospects for inflation, we may see interim volatility for the remainder of the year. But, beyond year-end we think that the recovery will extend through 2022. Thus any interim volatility this year may provide attractive opportunities to put cash to work or reallocate portfolios to capitalize on opportunities. That said, as described previously in many of our emails, we do not attempt to “time the markets”. The results of volumes of academic research argue against this practice. Subject to their individual situations, insightful investors characteristically keep their focus on the 18-month and longer horizon to inform their financial decisions. We at Atlas will continue to manage assets accordingly on behalf of our valued clients.

Please feel free to contact your Atlas Wealth Management Advisor if you have any questions about this or any other financial matter. As always, we are readily available to serve you.

[1] At the point when 89% of companies in the S&P had been reporting actual results for Q2 2021.


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