June 03, 2021 | eFocus @ Legacy, Investment Commentary

Record First Quarter Earnings Support Elevated Market Valuations

Connor O'BrienBy: Connor R. O’Brien, Trust Investment Officer

Changes to company leadership, new product releases, technical indicators, and investor sentiment are just a few of the countless factors that can cause short-term market fluctuations. However, over the long run, there is one factor that stock prices have a near-perfect correlation with – corporate earnings. While it is impossible to predict day to day market movements, identifying companies and industries with high potential earnings power is key to long-term investing.

As the first quarter earnings season wraps up, we think it is important to check in on just how strong corporate earnings have been coming out of the COVID-induced 2020 recession. Put simply, it is almost impossible to overstate how impressive S&P 500 earnings have been in the first quarter of 2021. A combination of vaccinations, fiscal stimulus, and pent-up demand, along with an easier comparison to COVID-depressed 2020 earnings, have propelled both the rate at which companies are beating estimates and the magnitude by which they are beating expectations to record levels.  This huge recovery in earnings helps explain why the S&P 500 sits near all-time highs despite potentially higher tax rates and the recent pickup in inflation.

With Q1 earnings season almost wrapped up, blended year-over-year earnings growth for the S&P 500 is projected to be over 51.5%! If that number holds, it would be the second highest year-over-year growth in earnings ever recorded, behind only Q1 2010. This is also more than triple the Q1 earnings growth that analysts were predicting to start the year.

Of the companies that have reported, 86% have reported actual earnings-per-share above analyst estimates, compared to the 5-year average of 76%. In aggregate, companies are reporting earnings that are 22.5% above analyst estimates, the second-highest earnings surprise percentage reported by the index ever, and well above the 5-year average of 6.9%. Not only is earnings growth blowing away expectations, but companies are more profitable than ever. The blended net profit margin for the S&P 500 is 12.8%, the highest net profit margin since FactSet began tracking this metric in 2008. Keep in mind, the first quarter historically tends to be one of the weakest quarters of the year on a seasonal basis.

Which companies and industries, specifically, have contributed to such strong earnings numbers? Emerging from a recession, we would expect that the most cyclically sensitive industries would benefit the most from a rebound in economic activity, and this is precisely what has happened. The largest contributors to the strong Q1 earnings growth are banks, consumer-focused stocks, and communication services. Higher interest rates and a lack of defaults have supported banks, fiscal stimulus has propelled consumer spending to all-time highs, and an acceleration in ad-spending has supported digital advertisers like Facebook and Alphabet.

Looking ahead, growth does not look to be slowing any time soon. Analysts are projecting earnings growth of 59.9%, 22.2%, and 16.9% for each of the next 3 quarters, respectively. Bundle it all up and we are looking at earnings growth of over 35% for the 2021 calendar year, compared to an earnings decline of -14% in 2020. Even if we do get a corporate tax rate increase in late 2021 as many are expecting, it should not put more than a few percentage point dent in 2022 earnings, with analysts expecting 11.9% earnings growth next year.

Strong earnings growth is key to support elevated valuations. Right now, the S&P 500 currently trades at roughly 21.5x next twelve month’s earnings, compared to a 5-year average of just above 18x. This expansion in valuations has been due to high anticipated earnings growth and a low interest rate environment. Many financial journalists and market analysts are predicting, as interest rates increase and earnings growth eventually slows, the market to reset to the longer-term averages of 16-18x forward earnings. There are essentially two ways for this to happen; a 25% decrease in prices, or growth in earnings of 25%.

Fortunately, many analysts are expecting close to 25% earnings growth over the next two years, and that even a higher corporate tax rate will not impede companies’ ability to generate profits. While many people assume that a market correction is needed for valuations to normalize, an increase in earnings is arguably a more likely (and much less scary) scenario!

What investors will pay for stocks in the future is unanswerable, and analysts estimates are always subject to change. However, as the first quarter wraps up, it has become clear that corporate earnings of US companies have never been stronger.

If you are a Legacy client and have questions, please do not hesitate to contact your Legacy advisor. If you are not a Legacy client and are interested in learning more about our approach to personalized wealth management, please contact us at 920.967.5020 or info@lptrust.com.

This information has been prepared by Legacy Private Trust Company for informational purposes. Any opinions expressed herein represent our current analysis and judgment and are subject to change. Actual results, performance, or events may differ based on changing circumstances. No statements contained herein should substitute for professional legal, tax, or other specialized advice.