If you’re wondering why stock prices keep going up, the most likely explanations are: 1) the Fed has promised to keep interest rates low indefinitely, and 2) trillions more in fiscal stimulus are in the pipeline. But there is another contributing factor. Corporate earnings are coming in much better than expected for the fourth quarter, and that outperformance is leading analysts to further boost their earnings estimates for the next few years. The consensus estimate for S&P 500 earnings in 2021 is now 24% above the figure expected for 2020. For 2022, analysts now expect S&P 500 earnings to grow to over $198, which would represent a gain of 15% over 2021. And estimates call for another 12% earnings growth in 2023. Using these estimates, the companies in the S&P 500 are now expected to grow earnings at a compound annual growth rate of 17% from 2020 to 2023. If these types of growth rates are indeed achieved, we will be able to look back on the COVID nightmare as just a blip in an otherwise upward trajectory for US corporate earnings. Sound too good to be true?
According to data acquired from Bloomberg, 358 out of the 500 companies in the S&P 500 have reported their fourth quarter results so far. Around 79% of the companies that have reported have beaten their consensus earnings estimate while 72% have beaten their consensus sales estimate. The average sales beat was around 4%, and the average earnings beat was a whopping 18%! Now, there is always a bit of sandbagging that goes on when corporate management teams provide earnings guidance. They nearly always set the bar low enough to easily clear. But 18%?!? How could analysts be off by that much?
But more to the point, it would seem there is a growing disconnect between the health of US businesses and the health of the US economy. How do we know that? Well, for one, consumer spending accounts for over two-thirds of US GDP, and there are still nearly nine million fewer people working (-5.5%) than prior to the COVID’s arrival. For another, nonresidential fixed investment, which is a proxy for business investment and usually accounts for 14%-15% of GDP, is still coming in at levels we saw in late 2018. If 80%-85% of the economy is still struggling, it’s hard to see a robust economic recovery. The Congressional Budget Office (CBO) seems to agree. In its most recent projections earlier this month, the CBO said it expects the economy to grow at just a 3.2% average rate (inflation-adjusted) from 2020-2023 after dropping the most in seven decades in 2020 (-3.5%).
In the chart below, we compare the growth in the US economy since 2007 (incorporating two recessions) with the growth in S&P 500 earnings since that year. The projections for future S&P 500 earnings are from FactSet, and the projections for GDP are based on the CBO’s latest projections (February, 2021). You will see that S&P 500 earnings predictably declined during the both the Great Recession (December, 2007- June, 2009) and the steep COVID-driven downturn in 2020. What is interesting, though, is that the current S&P 500 estimates for 2021-2023 appear to completely disconnect from the trendline in GDP, as estimated by the CBO. This expected disconnect raises several questions, at least for me:
- Is it even possible for corporate earnings to grow that much faster than the economy at large?
- What happens if inflation picks up, raising labor and commodity costs for businesses?
- What if interest rates rise, finally raising the cost of borrowing to buy back stock?
- If, as some economists predict, the share of national income that goes to labor is set to increase following many years in which owners of capital enjoyed disproportionate gains, what will that mean for corporate margins, earnings and stock prices?
- Wouldn’t the recent trends toward political populism support an increase in labor’s share of national income at the expense of those owning the capital?
Optimism around the pace of corporate earnings growth has been gathering steam for many months. Given the increasingly pollyannaish outlook, it is getting incrementally more difficult to justify the valuations that are predicated on such outsized earnings growth. We continue to advocate an approach that offers opportunities to both participate in further strength as well as protect against sudden or protracted weakness. High-quality stocks with strong balance sheets and competitive dividend yields seem most appropriate for this environment.