Today for Data we’re going to consider two simple, interrelated questions: what can the S&P 500 earn in 2021, and what do current stock prices expect? We will answer that question with our customary 3-point format:
#1: Let’s begin by looking at Wall Street’s 2021 earnings estimates, not because they are right but because they are often reliably wrong. FactSet notes in its most recent Earnings Insight report that over the last 20 years analysts have, on average, been high by 7 percentage points at the start of a given year. If the S&P 500 earned $93/share in year X, analysts were estimating $100/share at the start of that year.
The following chart shows, however, that there are 2 environments where Wall Street underestimates US corporate earnings power: at the very start of an economic cycle and towards the end. In the first instance, analysts are unsure of the pace of economic recovery and play it safe with low estimates. In the second, they underappreciate the strength of late-cycle earnings growth.
You can see this by looking at the 2010 Wall Street estimate (dark blue, $79.96/share) as compared to the actual result (light blue, $87.11/share) and the 2018 record as well ($147.46/share expected, $161.45/share actual):
The upshot here: take Wall Street’s official 2021 estimate of $169/share, adjust it by 2010’s early-cycle outperformance (+9 percent actual versus expected) and you get $184/share. That is a very reasonable way to answer the question “what does the market actually expect for 2021 earnings?” FactSet notes that “there is a possibility that EPS estimates for CY 2021 will increase after the start of the year once there is more clarity around timetables for mass vaccinations…” Markets are not waiting for Wall Street analysts, however. They seldom do …
#2: We’re big believers that near-term market volatility centers on investor expectations for corporate earnings 6 months out. The present quarter is easy enough to predict (ex a crisis), and the next quarter out can only be marginally different. But get past the next 180 days, and a lot can happen.
Here is FactSet’s calculation of Wall Street’s aggregate quarterly corporate earnings expectations through Q4 2021. Note that Q3 and Q4 2021 run around $45/share each quarter, noticeably higher than the $37/share to $40/share of Q4 2020 through Q2 2021.
Upshot (1): a $45/share quarterly earnings run rate equates to a $180/share annual run rate, very close to the $184/share calculation in the prior point. Both are reasonable approaches to assess how investors might be handicapping actual 2021 earnings power.
Upshot (2): the S&P is currently trading for 20x $182/share (the average of the analyses above) of 2021 earnings. In our book that is a reasonable early-cycle valuation because imbedded in that multiple is the chance for further cyclical earnings improvements in 2022 and beyond. Make no mistake, however: 20x is only reasonable as long as companies continue on a path of both better reported earnings and show investors that road is not at an end.
#3: As much as corporate cost cutting is helping boost near term earnings, you don’t give a 20x multiple for reducing headcount or slashing CapEx; 2021 has to show substantial improvement at the top of the income statement. Revenue growth drives sustainable marginal earnings growth.
At the simplest analytical level, we can look at this year’s -1.8 percent decline in S&P 500 revenues and compare that to Wall Street’s expectation of a +7.7 percent aggregate sales increase and say, “Of course there’s plenty of potential operating leverage!” Revenue growth of 8% should easily provide the backdrop for 15-20 percent normalized earnings growth assuming the typical corporate cost structure is 50 percent fixed/50 percent variable.
But let’s stress-test that idea by looking at the sectors where this revenue growth is supposed to come, because not every industry has the same fixed/variable cost structure. Here is the FactSet chart with 2021 expected revenue growth by sector:
Upshot: sure enough, all the sectors with higher-than-average expected 2021 revenue growth are industries with high fixed costs and therefore high contribution margins from incremental revenues. Energy, Consumer Discretionary, and Industrials are the easy examples. Communication Services includes Google and Facebook, both of which have significant earnings leverage from incremental ad sales in an economic recovery.
Summing up (1): as much as the recent melt-up in US stocks may feel like a magician’s levitation act, there is a tangible fundamental framework that undergirds this illusion and makes it physically possible. Specifically, markets know Wall Street’s earnings estimates are too low because they’re always too low at the start of a cycle. The “whisper number”, for lack of a better description, is $182/share versus the Street’s $169/share. Given that the best revenue expectations belong to high fixed cost sectors, that whisper might be too low.
Summing up (2): not to end on a down note, but our long career as a cyclical industry analyst reminds us that “buy the rumor, sell the news” aptly describes how markets trade upside earnings surprises. Over the short term, there’s more room for optimism. That’s especially true if we do get a large fiscal stimulus package. But there will be a time in 2021, likely in Q2 – Q3, when Street expectations are finally correctly calibrated. And then stocks may not work as well as now.