Earnings season has been great with profit margins holding up in the face of inflation
A quarter of the way through earnings season, we are headed toward the best profit growth in over a decade.
One-fourth of the S&P 500 has now reported second-quarter earnings. Overall earnings are now expected to grow 76% year over year for the period, according to Refinitiv, the best growth since 2009.
Why are stock prices still near record levels?
Still, the trading community has been well aware that Q2 would be a historic quarter, likely the "peak" of earnings growth. The S&P 500 has continued to hover just shy of record highs for other reasons:
Estimates are continuing to rise for the third and fourth quarters. While the rate of growth for earnings is slowing, they are still growing. Third-quarter earnings are expected to rise 27% from a year earlier, up from 20% on April 1.
Fourth-quarter earnings are expected to rise to almost 20%, up from 13% on April 1.
Profit margins are holding up. Other than consistent earnings growth, nothing is more important for fundamental investors than profit margins — the percentage of sales that turn into profits. Investors have been terrified by reports of exorbitant increases in the cost of raw materials, and of much higher wages in certain industries (particularly services), all of which could significantly erode margins.
So far, with a few exceptions, the fear has not been justified. While margins for the S&P 500 have typically been at the 9% to 11% range for the past five years, the first quarter saw margins at 13.0%, a historic record. Second quarter to date is seeing margins at 12.8%, according to S&P Global.
Why are margins holding up so well? While companies are reporting higher costs, they are being offset by pricing power.
"While the benefit of NOLs [operating leverage] is certainly fading and inability to pass on rising input costs is a risk for a short list of S&P 500 companies, in aggregate net income margins should remain well-supported and costs should be offset by pricing power and operating leverage," Dubravko Lakos-Bujas, chief U.S. equity strategist for JPMorgan, said in a recent note to clients.
"Households are well positioned to absorb rising costs given elevated household savings and strong labor market," he added.
Operating leverage is providing additional earnings growth. Last year, companies dramatically cut costs by reducing travel, cutting down on real estate expenditures, and cutting jobs. As revenues have started to improve, more of those additional revenues go to the bottom line, an effect known as operating leverage.
Despite the effect of the pandemic on profits in early 2020, Nicholas Colas, who analyzes market trends as head of DataTrek, notes that this is the culmination of two remarkable years of growth: "In the 2 years since Q2 2019 the S&P 500 has generated 17 percent earnings growth on 3 percent revenue growth. ... That stands in stark contrast to the 2011-2019 period, when earnings grew much more slowly."
Covid variants are not derailing the recovery. A more recent source of worry has been the emergence of more contagious Covid variants, which has created considerable confusion on how much protection vaccines would provide to those who are vaccinated and the extent to which there may be new regional lockdowns in the late summer and fall, particularly in regions with low vaccination rates.
So far, CEO commentary has been generally muted.
"We haven't seen any impact at all from the variants," Delta Air Lines CEO Ed Bastian said on CNBC on the day the company reported earnings. "When we monitor our bookings, we have pretty good visibility 60 to 90 days out. ... We haven't seen an slowdown or downtick in bookings."
It is early in earnings season, so CEO commentary may turn more cautious if hospitalizations increase dramatically.
For the moment, the market is running with the narrative that the variants may slow the recovery, but not derail it.
Have the markets dodged yet another bullet?
So far, the second quarter is continuing the strong upward trend that has characterized the market for the last several quarters.
"This shift in marginal profitability is a key reason US large caps remain resilient," Colas said. "We're still a bit cautious near term due to seasonal volatility patterns, but the 2019-2021 step up in marginal profitability keeps us solidly bullish longer term."
JP Morgan's Lakos-Bujas also remains bullish. "Overall, greater than 10% earnings surprises and positive guidance on revenue and margin estimates this earnings season should help dismiss some perceived fears around stalling growth momentum, especially ahead of what should be a record setting back-to-school and holiday season in the US," he said.
What could go wrong?
While earnings estimates are still rising, the rate of change is slowing. "Last earnings season, analyst estimates were typically rising 5% after company reports," said Nick Raich, who analyzes corporate profits at Earnings Scout. "This quarter, they are rising 3%."
Historically, Raich says, that implies the multiple on the S&P 500 (the price investors are willing to pay for $1 of earnings) should start to contract. The multiple expands when expected profitability expands, and it contracts when it gets weaker.
But Raich believes it is still too early to make that call. "We think stock prices are going to continue to go higher into year-end, as long as the estimates keep rising," he said.