The looming election has garnered a lot of attention from investors and inspired many commentaries. With a lot of eye on the polls, company cash flows have taken a backseat—but that’s likely to change as earnings season kicks into high gear in the coming weeks.
Similar to the last two quarters, analysts expect Q3 to deliver further broad-based earnings declines to the tune of -20.5% on a year-over-year basis. It’s ugly, but better than the 31.6% decline witnessed in Q2. Q3 results should be helped by the reopening of economies and businesses.1 However, it is worth noting that this is the sixth instance in the past seven quarters where the S&P 500® Index has reported a year-over-year decline in earnings.2 So, while the magnitude is now much greater, the trend of negative growth was certainly evident pre-pandemic.
With more declines on the way and the pandemic still impacting results, there are three trends worth watching during this earnings season, as highlighted in our recent chart pack and summarized below.
Earnings bar not much lower
Q2 earnings for S&P 500 stocks beat expectations by 12.5 percentage points, stemming from a record-high percentage of companies reporting positive earnings surprises (84%).3 The magnitude of the earnings beats were also a record (+23%), creating a dynamic where firms that beat on earnings were rewarded by the market in the days following earnings announcements more so than the five-year average (1.4% versus 0.9%).4 Before all of this positivity, however, Q2 earnings estimates were slashed by 30%.5
Q3 is not as lucky to have such a low bar. While Q3 earnings estimates are projected to decline by more than 20%, the actual figure has been positively revised over the last few weeks, as shown below.
Source: Bloomberg Finance L.P. as of October 12, 2020. Characteristics as of the date indicated.
The bar is clearly higher for Q3. As a result, investors should not expect firms to clear it at the same rate or magnitude as they did in Q2. In other words, the earnings tailwind the market enjoyed last quarter is unlike to be felt this quarter. This all points to heightened fundamental uncertainty at a time when macro uncertainty will be reaching its apex (i.e., the US election).
Strongest earnings sentiment by sector: 2 cyclicals + 1 defensive
Currently, firms in the Industrials, Consumer Discretionary, and Health Care sectors have the strongest earnings sentiment based on our composite score, as shown below. This metric is a combination of recent earnings revisions as well as surprises.
The strong scores for Consumer Discretionary and Industrials are the result of recent upward revisions, driven by two components. First, revisions were made to low base figures, which must be appreciated. Second, the upward revisions reflect the reopening of some aspects of our economy and supply chains. The latter point is reinforced by the fact that 35 of the 60 companies in the Consumer Discretionary sector have seen their earnings-per-share (EPS) estimates revised higher by more than 10% during the quarter—although many of the firms will still report sizable losses.6
Source: SPDR Americas Research, FactSet, Bloomberg Finance, L.P. as of September 30, 2020. Green shading is top 3, red shading is bottom 3. *The scorecard uses z-score for each metric to standardize numbers across sectors and show relativeness among sectors. Composite score is calculated by equally weighting each metric in the same category. Z-score indicates how many standard deviations an element is from the mean. A z-score can be calculated from the following formula. z = (X - μ) / σ where X is the value of the sector. μ is the mean of the eleven sectors. σ is the standard deviation of eleven sectors. S&P 500 sector indices are used to calculate sector scores.
Health care, a more defensive sector, is the lone outlier among the top three sectors with improving sentiment—but it’s not an outlier just because of its cyclical tendencies. Rather, sentiment is improving due to what the full-year and quarterly results are projecting: The Health Care sector is projected to post a minor 0.4% decline in earnings for Q3 with a 4.7% increase in Q4, making it one of only four sectors to have positive EPS growth in 2020. Revenues are also expected to be positive, reaching the highest level of any sector across the Q3, Q4 and 2020 time periods.
Conversely, the Industrials and Consumer Discretionary sectors are expected to report large losses, though results are expected to improve heading into 2021 as discussed above. In fact, the two segments are expected to post the largest growth next year.7
Overall, positive earnings sentiment for these three sectors is emblematic of progress in reopening portions of the economy—but it is also a recognition of how important a health care solution is going to be for our society to make a full recovery.
While fundamental risk is low for the Health Care sector, macro risk is high. It is one of the sectors potentially in play based on election policies. It could also be impacted by the nomination of Amy Coney Barrett to the Supreme Court. The week of the likely date of the floor vote (October 23) plus the week following will coincide with earnings reports from 57% of S&P 500 Health Care firms.8
For the Industrials and Consumer Discretionary sectors, price reaction is more skewed to the downside because of fundamental reasons, considering the bar has been moved higher. Any cautious tone or miss in expectations could lead to outsized price moves. Furthermore, 55% of Consumer Discretionary firms report after the election.9
Optimism apparent overseas, too
Upbeat earnings sentiment is also emerging overseas. As shown below, the three-month up-to-downgrade ratio for both developed ex-US and emerging market (EM) stocks has increased every month since April. While the ratio is still less than one—indicating more downgrades than upgrades—the trendline is encouraging and led by EM stocks. Additionally, EM is expected to post a shallower decline (-12%) in full-year 2020 EPS growth compared to the US (-20%) and developed ex-US markets (-30%).10
Source: FactSet, as of September 30, 2020. Characteristics are as of the date indicated, are subject to change, and should not be relied upon as current thereafter. EPS growth estimates are based on Consensus Analyst Estimates compiled by FactSet.
While the risks to earnings for overseas companies are the same as in the US, valuations in EM are constructive on a relative basis. Across three of four key metrics, EM is trading at a larger relative discount than seen in the last 15 years;11 the fourth discount metric is at the historical median.12 For investors looking to capture positive earnings trends, overseas equities may be less expensive—in terms of the multiple an investor pays for them—than broad-based US stocks.
The election earnings season
By November 3, almost 65% of the S&P 500 will have reported earnings,13 providing a real-time update on the health of company cash flows. However, the outcome of the election may change the trajectory depending on the ensuing policies that may come to fruition.
Nonetheless, if the positive earnings trends described here persist and firms are able to beat the raised bar ahead of the election results, it may add resilience and durability to the recovery—which would be particularly needed if short-term macro uncertainty does indeed take over. If results disappoint, it will mark yet another source of risk for investors to confront in 2020.
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1 FactSet as of September 30, 2020
2 FactSet as of September 30, 2020
3 FactSet as of September 30, 2020
4 FactSet as of September 30, 2020
5 FactSet as of September 30, 2020
6 FactSet as of September 30, 2020
7 FactSet as of September 30, 2020
8 Bloomberg Finance L.P. as of October 12, 2020
9 Bloomberg Finance L.P. as of October 12, 2020
10 FactSet as of September 30, 2020
11 Price-to-earnings, Price-to-book, and Price-to-Sales as of September 30, 2020 per FactSet data
12 Price-to-next-twelve-month-earnings as of September 30, 2020 per FactSet data
13 Bloomberg Finance L.P. as of October 12, 2020
MSCI EAFE Index
An equities benchmark that captures large- and mid-cap representation across developed market countries around the world, excluding the US and Canada.
MSCI Emerging Markets Index
The MSCI Emerging Markets Index captures large and mid-cap representation across 23 emerging markets countries. With 834 constituents, the index covers approximately 85% of the free float-adjusted market capitalization in each country.
S&P 500 Index
A popular benchmark for US large-cap equities that includes 500 companies from leading industries and captures approximately 80% coverage of available market capitalization.