Loss, Strain & Butterflies: Earnings Plunging, Stocks Ignoring

Key Points

  • Profits are central to stocks’ long-term returns, but they often disconnect; with stocks typically leading turns in corporate earnings.

  • Valuation analysis—futile with today’s rapidly-plunging earnings estimates—is also significantly colored by investor sentiment conditions.

  • The spread between bottom-up and top-down estimates for S&P 500 calendar year earnings is exceedingly wide; with bottom-up analysts stymied by disappearing guidance.

The relationship between corporate earnings and stock prices is quite a bit more complicated than what’s inferred by classic phrases like “earnings are the mother’s milk of stock prices.” There are times they are glued at the hip; but others when they move in completely opposite directions—even if over the long run, profits are central to stocks’ returns. Even valuation—in this case, as measured by the price/earnings (P/E) ratio—has a murky filter over it.

Valuation = sentiment indicator

Yes, it’s easy to quantify the P (of a stock or an index) at any point in time; and yes, it’s easy to quantify the E at any point in time (certainly trailing earnings, which are already in the books). But the reality of valuation is that it’s as much a sentiment indicator as it is a “fundamental” indicator. It was the euphoria of the time that had investors willing to pay nosebleed multiples for the S&P 500 in late-1999 and early-2000; while it was the despair of the time that had investors unwilling to pay even single-digit multiples in late-2008 and early-2009.

In the COVID-19 world in which we are all living, trying to do anything resembling traditional earnings and/or valuation analysis is proving to be a somewhat-futile task. But the questions have been coming at me at a fast pace from investors and the media as to how/why the stock market could have rallied so significantly off the March 23 low in the face of what is likely to be the disaster-to-come for corporate earnings. So let’s see if we can unpack things a bit.

Looking ahead

We are still early in first quarter earnings reporting season with only about 10% of companies having reported. However, even if we were further along, it would still be the case that reports for the quarter that’s already past will be less relevant to assessing the health of corporate America, given that two of the three months were largely pre-COVID-19 economic shutdowns. As is even the case in a normal environment, what companies have to say about their near-term future is more impactful than what they said about the quarter in the rear-view mirror.

In aggregate, S&P 500 companies have so far reported earnings that are 6.3% below expectations, which compares to an average of 3.3% above expectations since 1994. But it’s the forward-looking estimates that are more relevant given the current environment. You can see in the table below the tally of growth rate estimates on a quarterly basis for the overall S&P 500 (bottom row) as well as each of the 11 S&P sectors.

Source: Charles Schwab, Bloomberg, I/B/E/S data from Refinitiv, as of 4/17/2020. Estimates of future earnings are hypothetical and for illustrative purposes only.