High Stakes, Peak Profits

Earnings season kicks off in earnest next week, and the stakes could scarcely be higher.

I’m just kidding. I mean, I guess the stakes are high. But that opening line is just a humorous riff on the kind of dramatized lead-ins that make for “good” financial journalism.

Analysts expect corporate America to post profit growth of more than 60% for the second quarter (figure below).

Obviously, this will mark “peak” profit growth. Comps will get harder from here, there are no more stimulus checks in the offing, margin pressures are mounting and concerns that the “Delta” variant could hamper the economy are starting to manifest in falling bond yields and underperformance for reflation-linked equity expressions.

Toss in market jitters around the timeline for Fed tightening and the prospect of higher taxes, and you’re left with a recipe for — I don’t know, de-rating I guess.

You’ll forgive the casual, dismissive tone. I try not to inundate readers with boilerplate copy. When I’m compelled to, I can’t help but lapse into a colloquial cadence.

The truth is, you don’t need anyone to tell you that valuations are stretched, that input costs are rising, that wage pressures are building, that stocks prefer a dovish Fed and that a more aggressive COVID variant is a problem when 52% of Americans still aren’t fully vaccinated.

As such, these types of articles are really just an exercise in recitation. Can you recite the narrative? Are you a “good” armchair analyst or aren’t you? Do you know what’s going on, in a kind of general sense?

A more generous take would be to call this “obligatory prep.” Now you’re “apprised” of what analysts expect. They’re looking for blockbuster earnings growth amid a peaking US economy and a base effect tailwind. The figure above is the 30,000-foot view. The figure below (from Goldman) is the granular breakdown.

“In part, S&P 500 EPS growth will benefit from base effects,” Goldman’s David Kostin wrote, stating the obvious (that’s not a criticism of Kostin — sometimes, the obvious needs stating). “Economic growth is the main driver of EPS growth and our economists forecast US GDP growth of 13% YoY in Q2,” he added, noting that “consensus expects 22% sales growth and that net profit margins will expand by 256bps to 11.1%.”

The most spectacular growth numbers will come from cyclicals and other sectors disproportionately crushed by the pandemic in Q2 2020. Financials will likely account for nearly a quarter of the index’s bottom-line growth. For the third straight quarter, banks should benefit from reserve releases.

As for Facebook, Amazon, Apple, Microsoft and Google (the “Big Five”), Kostin reminded folks that “despite last year’s acute Q2 economic contraction, these firms actually posted average EPS growth of 38%.” And yet, they’re still seen growing earnings by more than 50% (on average) when they report.

There will be the usual protestations around valuations being woefully detached from reality, even if firms manage to beat estimates. For example, Bloomberg, citing DataTrek, noted that if you “assum[e] the S&P’s P/E ratio go[es] back to the five-year average of 18,” the benchmark is pricing in around $240 a share of aggregate earnings, some 14% above analysts’ full-year estimate for 2022. “Markets need to see a clear runway to an S&P 500 2022 earnings number of $240,” DataTrek co-founder Nicholas Colas remarked.

Then again, you can justify just about any valuation if you’re inclined to lean on the old “it’s all relative” talking point (figure below).

And besides, who cares about profits anymore? Half the time (and I mean that in the casual, everyday sense of the phrase, not literally 50% of the time) reported “profits” aren’t really “profits” at all. And as we’ve seen over the past year, it’s cool to be unprofitable these days. If you’re bankrupt (or about to be) that’s even better.

In the same linked article, Bloomberg rolled out a pointless statistic. Going back to the 1920s, the S&P dropped, or otherwise underperformed, around 66% of the time when earnings momentum began to decelerate.

One useful tip for identifying meaningless factoids is to ask yourself whether they’ll be trotted out again, post-whatever it is that’s under discussion. Imagine someone writing this headline six months from now: “Stocks Ignore Waning Profit Momentum To Perform Feat Only Witnessed 33% Of The Time.”

Now laugh. And, please, forgive my biting sarcasm.