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US earnings season is always a spectacle and this time around is no different. Well, no different but for one exceptional factor: Covid-19, and its effects on company profits. The businesses that make up the S&P 500 Index have started to tell us how they performed from January to March, a period of unprecedented operating conditions.
While some effects of the pandemic are apparent in the reports we’ve seen so far, we must remember that the US was one of the slowest countries to enter lockdown. In many states, the order to stay at home came only in the final week of March. Still others didn’t lockdown until early April. As a result, first-quarter company results can’t show the full consequences of the economic shutdown. To see those, we must wait until the second-quarter earnings season.
Nevertheless, other data has already painted a very bleak picture of the global economy’s health. Reports show collapsing retail sales, weak small-business confidence and job losses. In addition, the oil price has plummeted. But for an idea of what might happen to company profits, we can look at how analysts are using this information and changing their forecasts.
The ratio of positive changes (upgrades) versus negative changes (downgrades) made by analysts is shown in the chart below. A reading below zero means that, as a group, they have made more downgrades than upgrades to their earnings predictions.
Analysts’ revisions to S&P 500 earnings (ratio of upgrades to downgrades)
Source: Refinitiv, IBES
The current reading of -90% is the lowest ever recorded, plumbing depths that we didn’t see even during the global financial crisis (GFC). At the start of the year, the consensus among analysts was that earnings per share (EPS) would grow about 10% in the first quarter compared to the same time a year before. Taking all of these downgrades into account, forecasters now think that earnings growth will be 12.5% lower than it was in January to March 2019. Predictions vary considerably across the sectors, however. Some areas of the market, like consumer discretionary, financials and energy, could see growth decline by up to 40%. On the other hand, for sectors such as tech, consumer staples and healthcare, EPS could grow at a level in the mid to high single digits.
For the second quarter, analysts think overall EPS growth will be down 39% compared to last year. That is some difference, and we think that even these negative estimates are too high. Why? Because we know that global lockdown measures have brought activity almost to a standstill!
What of the numbers from the companies themselves? At the time of writing, more than half of S&P 500 companies have made their reports. But there is a tendency for the very largest companies to make their announcements first. This half therefore accounts for nearly three-quarters of the index’s market capitalisation.
Looking at the actual count, so far, more companies have exceeded expectations than failed to meet them. This is not unusual: unsurprisingly, companies and their shareholders like to beat forecasts. There’s an easy way to achieve this – they simply lower expectations shortly before releasing the figures.
What’s interesting is that this quarter’s earnings surprises (whether positive or negative) paint two separate stories.
What’s interesting is that this quarter’s earnings surprises (whether positive or negative) paint two separate stories. Cyclical sectors comprising economically sensitive companies – consumer discretionary, financials, energy etc. – delivered the vast majority of the misses. On the other hand, earnings for large internet stocks, and in defensive sectors such as utilities, held up well.
What is more interesting is that the number of misses has increased substantially from previous quarters. We observed a similar trend during the last recession. There are exceptions, of course. By the end of March, the scale of the pandemic and some of the effects of global lockdowns were coming to light.
Increased sales of over-the-counter drugs, along with the urgent search for a cure or a vaccine boosted profits in the healthcare sector, for example. And consumers, knowing that lockdown was coming, boosted profits at food producers and retailers by stocking up in advance. Tech is another area where earnings are beating expectations. With a large proportion of the workforce now working from home, demand for communications solutions and cloud computing services has skyrocketed. Media streaming services have also been in high demand. The tech-heavy NASDAQ Composite touched reached a record high during February. Microsoft CEO Satya Nadella summed up the trend well when he said that the company’s clients had “…seen two years’ worth of digital transformation in two months.”
While we’re all keen to see this earnings information, it really is like looking in a rear window. It gives us a picture of what has already happened, not what is still to come. What is more useful for investors is understanding what companies think is going to happen to their profits over the next year or so. In general, only about half of the companies in the index have ever released future earnings guidance. But even these businesses have begun to withhold their projections. Companies that have decided not to give future guidance include IBM, Caterpillar and the industrial conglomerate 3M. Investors have not taken the news, or lack thereof, well. In the past, shares in companies that have withheld guidance have underperformed the wider market.
Needless to say, the lack of corporate guidance also presents a challenge for the analysts who cover these companies. With key information missing for some stocks, what will they be considering when they make their assessments for the second quarter of 2020?
Looking at their combined projections so far, it’s clear that in general, they expect earnings to contract sharply this year, but to recover equally quickly in 2021. Analysts, like many others, are prone to be optimistic and investors have been showing their enthusiasm, too. April was a stellar month for US stocks, with the S&P 500 Index climbing almost 13%. We, on the other hand, think there are reasons to believe that profits might dip more substantially and then be slower to recover. Strong company profits growth is often a feature of stock markets’ recovery. But it takes time – roughly ten quarters, if previous recessions are a guide – to repair all of the damage. This sort of timescale is more in line with our economists’ predictions for corporate health in the months to come.
That said, analysts’ EPS projections differ more from each other than they do usually. One contributing factor is the aforementioned lack of guidance from companies. Another is their misgivings about when lockdown restrictions will end. This forecasting uncertainty is the case even for so-called defensive companies, whose profits are usually relatively predictable. No one has a crystal ball. All that’s clear is that the way ahead is decidedly foggy.
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