This earnings season likely will be the last of the earnings recession. After year-over-year declines in the first three quarters of 2020, the fourth quarter likely will make it four in a row. Looking ahead, earnings are likely to grow solidly in the first quarter 2021 and throughout the year, which we think will enable stocks to grow into their lofty valuations.
Expect Modest Earnings Decline
We expect solid upside to S&P 500 corporate earnings relative to current estimates. However, expecting a year-over-year increase may be too much to ask. Consensus is calling for a roughly 8.5% year-over-year decline in earnings per share (EPS) according to FactSet’s estimates [Figure 1].
We expect earnings to surprise to the upside by a solid margin again this quarter for a number of reasons.
Higher estimates. Estimates for the fourth quarter have risen by about 2.3% since October 1, 2020, which signals companies will be able to deliver at least the typical several percentage points of upside. Estimates typically decline by about 4% during a quarter.
Guidance has been very positive. A very high 66% of companies that provided guidance during the fourth quarter guided numbers higher. That percentage is significantly higher than the five-year average of 33%.
Manufacturing is booming. The Institute for Supply Management (ISM) manufacturing index reached its second highest level in 15 years in December (60.7). Historically, the ISM index has been a leading indicator of upside earnings surprises and correlated well with corporate profit growth.
Solid economic growth. Even though some economic data—particularly the jobs report and retail sales for December—has suggested that a pause in the economic recovery occurred in late 2020, the US economy likely grew in the quarter. Bloomberg’s consensus gross domestic product (GDP) growth for the fourth quarter is 4.2% annualized. Even though economic surprise indexes (measures of how frequently economic data exceeds expectations) weakened some during the quarter, they remained in positive territory.
So how good could numbers be relative to expectations? The US economy’s soft patch that developed late last year amid the latest wave of COVID-19 may limit upside. Also consider that the bar has been raised substantially over the past two quarters, making it tougher to clear. That probably takes positive earnings growth off the table, but a low-to-mid-single-digit decline in earnings would be a positive outcome, especially if forward estimates hold up as fresh guidance is provided. Further, just getting last year’s results fully behind us and turning investors’ focus more to 2021 should help buoy investor sentiment.
Four Key Earnings Questions
We’d like to get answers to four key questions this earnings season:
1. What will the impact of COVID-19 be in the first quarter of 2021? The increase in analysts’ earnings estimates—as we saw last quarter—reflects increased confidence in the profit outlook despite the ongoing pandemic. However, new restrictions imposed late in the quarter that remain in place today may temper enthusiasm for the earnings recovery in early 2021.
2. Will results support continuation of the cyclical value trade? Cyclical value sectors such as energy, financials, and industrials have seen very strong performance of late. These sectors were top performers during the fourth quarter, have continued that momentum, and are each outperforming so far in 2021. Given that the latest wave of COVID-19 and resulting restrictions have caused an economic soft patch over the past couple of months, we think it’s fair to say there is some risk that results and guidance across these sectors may not be good enough to please the market.