Passing the peak
Passing the peak
Intro
This piece is mainly about passing the peak – in economic growth and corporate earnings growth. I’ll also touch upon the FOMC due on 21-22 September.
Earnings growth till now
After the March 2020 pandemic crash, analysts had underappreciated the strength of company earnings.
That usually happens after recessions. Estimates are cut too much and corporate profits rebound faster than expected as companies slash costs and focus on efficiency.
The economy may still be fragile but it’s coming off a strong rebound from pandemic lows. GDP growth is driving more sales and more of those sales is flowing to the bottom line, also thanks to operating leverage. And that’s why we have record corporate profits.
Future GDP growth
Estimates of GDP growth have been steadily coming down and currently stand around +3%, roughly half of the growth rate expected a few months back.
Growth will moderate. After being positive for over a year, the Economic Surprise Index has gone negative.
Rising inflation
The Producer Price Index, or PPI, is rising faster than CPI, which suggests that companies haven’t been able to pass on all their higher costs to consumers.
Companies such as 3M and Sherwin-Williams have offered disappointing guidance recently because of higher input costs, and those cuts are now showing up in earnings revisions.
Future earnings growth
This can fall for 5 reasons:
1. The unusually high growth rates of Q 1 and Q 2 2021 will not continue in the last two quarters as they largely reflected easy comparisons to the year-earlier periods that were severely impacted by Covid-related disruptions.
2. Slowing GDP growth
3. Continued supply chain issues – less revenue and less margins.
4. Rising inflation
5. Leisure, travel and hospitality sectors are still held down by the pandemic, with companies in these areas still earning significantly less than they did in the pre-Covid days. Many of these companies aren’t expected to get back to pre-Covid profitability levels for another year.
Earnings revision
Total Q3 earnings for the S&P 500 index are expected to be up +26.2% from the same period last year on +13.7% higher revenues.
So far, unlike Q3 GDP growth estimates, earnings expectations for Q3 have not been revised lower, but the revisions trend has nevertheless lost its earlier momentum. This loss of momentum is likely tied to the emerging economic slowdown, likely due to the Delta variant.
But it’s important to understand that peak earnings growth isn’t the same as peak earnings. The trajectory is higher but flatter.
We should focus on whether or not earnings estimate revisions could turn negative. There is no symptom or pattern of that in this market.
Plus, passing peak growth doesn’t mean weak growth.
Why does it matter?
Stocks are valued highly, but the price-to-earnings ratio of the S&P 500 has not been making new highs this year even as the market has been. Valuations are still rich so don’t expect much multiple expansion. Hence its earnings growth that has to drive stock price growth, and since EPS growth will slow, stocks can’t grow at that same old pace.
Peaking revisions can often precede a drop in stocks.
In 2000, with the collapse of the dot-com bubble—and the 2001 recession—on the horizon, earnings revision breadth hit a high just before the S&P 500 dropped more than 40%.
In 2010, there was another peak, which preceded a roughly 10% S&P 500 drop that year.
In 2018, earnings revisions crested again before the index dropped just over 10% in the first quarter of that year.
Fed meeting
Don’t expect anything new or dramatic.
Re: tapering, the Fed is likely to only discuss tapering at the upcoming meeting and, at most, signal it could slow the bond purchases later in the year. Expect an announcement in November and the actual cut in bond purchases to start before year-end.
If the economy sustains more damage from the Delta variant economy, then we could see a delay of the formal announcement from November to December 2021 or even January 2022.
Re: rate hike, the Fed may move its interest rate forecast forward slightly. In June, the dot plot showed two rate hikes for 2023 and none for 2022. If it does move, the Fed will have to explain why.