Earnings season kicks off in a couple weeks, and here's why it may be better than expected.
"September has been a rough month for global equities," Earnings Scout's Nick Raich said in a recent report to clients. "However, it has been a fantastic month for earnings."
Why all the optimism? Raich believes that based on early results, there is a very high chance that companies are going to be reporting substantially higher earnings than have been estimated, just as they did in the second quarter.
Raich points to the first 12 companies reporting, all of which have reported better than expected third-quarter results. Eleven of them — including Darden, FedEx, Lennar, Autozone and Nike — have seen their fourth-quarter estimates raised after their reports "by the greatest amount we have measured in a decade," Raich said.
Based on these early reporters, Raich believes there is a good chance the fourth quarter in general will also see earnings estimates rising as the quarter moves on, providing a further underpinning to the market in a seasonally up period.
It didn't begin that way. Analysts started out with estimates that the S&P 500 would see a drop of 25.3% this quarter, the second-largest drop since the second quarter of 2009, according to FactSet.
Then, as the reopening story got better, the numbers got better. Today, earnings are expected to decline 21.2%. That's still a big drop, but an improvement.
That is unusual. Earnings estimates for the S&P 500 third quarter are 3.7% higher now than at the start of the quarter, well above the usual trend that sees estimates decline by about 5% from the beginning to the end of the quarter, as analysts are typically too optimistic.
Not this time. Analysts seem to be underestimating the extent to which the U.S. economy is slowly improving.
Still, this all needs to be taken in context. First, a 21% decline in earnings is still a big drop. Second, companies are continuing to withhold earnings guidance. Only 67 S&P 500 companies have issued EPS guidance for the third quarter, well below the five-year average of 104, according to FactSet.
That makes it much more difficult to forecast earnings accurately.
Third, the reopening story could get very rocky, which would derail some of the optimism, as it did a couple weeks ago.
Where does this leave investors? Investors are clearly responding to the "earnings-are-getting-better" story, but why is the market still so choppy? As UBS' Art Cashin has pointed out, the market is largely dominated by momentum around Covid, not by fundamental analysis around earnings and valuation.
"There is only one game in town, and that's this Covid-resistant play," he told me last week.
When the reopening situation goes well, investors rotate into cyclical and travel stocks. When it gets murky, as it did in the second half of September, investors start rotating back into megacaps and work-from-home names, since it's believed they will be beneficiaries if the situation improves, and beneficiaries if it gets worse.
"This has been a narrow and singular rally," Cashin said. "I buy Covid-defensive stocks like Apple. So it goes up, then it goes down big because it hits the sell stops. The momentum guys are keeping very tight sell-stops to avoid getting caught up in a big reversal."
This, of course, leads to valuation issues, which we saw in abundance with all the megacap names in September. But until the reopening situation is clear, Cashin says, playing megacaps and the work-from-home theme is the main game in town: "It's wash, then rinse, then do it all over again."
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