Will third quarter earnings support further gains?
Following the S&P 500 Index’s first monthly decline in the last eight and a choppy start to October, investors will be looking to third-quarter (Q3) earnings season — which unofficially begins this week with a string of banks reporting — to help provide market direction.
There are plenty of reasons for investors to be cautious heading into what has historically been one of the most volatile months of the year; however, we believe corporate earnings are unlikely to put downward pressure on stocks for several reasons:
- Earnings growth remains robust. As of the end of September, consensus estimates project aggregate earnings to come in at $48.37. This represents a 27.6% increase from the same quarter of 2020. If this comes to fruition, it will mark the third highest year-over-year (YoY) increase since 2010. While there are lingering base effects from the pandemic-induced drop, earnings had largely recovered by the third quarter of 2020, making year-over-year comparisons more meaningful.
- Earnings estimates have increased during the quarter. This is a record fifth straight quarter in which we’ve seen aggregate earnings revised higher since the start of the quarter. Over the past five years (20 quarters) analysts have actually pared their estimates intra-quarter by an average of 2.9%. This recent trend is somewhat logical given the pandemic-induced drop in both sales and earnings that left many analysts — and corporate executives — uncertain as to future impacts on both metrics. Consequently, both erred on the conservative side, and some companies temporarily stopped issuing guidance altogether. Still, rising expectations from already-high levels bodes well for stocks to move higher.
- Broad sector participation in earnings and sales growth. Growth-oriented sectors have supported index-level earnings and sales growth for much of the past 18 months; however, cyclical value sectors are among those expected to post the best numbers in Q3. As of September 30, Materials and Energy are forecast to post the largest jump in both earnings and sales, while Materials and Industrials are expected to see the largest increase in net profit margins (Energy sector margins are forecast to be above the five-year average). This marks a continuation of trends seen in the second quarter, a period that saw Industrials post the largest YoY earnings increase, while Materials was also one of four sectors that outpaced the broader index. On the revenue side, Energy, Materials, and Industrials all bested the index average.
Strong (and increasing) earnings growth, led by sectors more exposed to the economic cycle, further supports our recommendation that a modest value tilt in investment portfolios may enhance return potential as the economy continues to reopen.
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