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Great Expectations: What Earnings Expectations Tell Us About Stock Market Returns in 2020
“People calculate too much and think too little.”
Charles T. Munger
Everybody Knows That Everybody Knows
Earnings are the primary determinant of future stock prices. Everybody knows that. Investors are taken aside early in the Investing 101 class, before committing their first dollar, and this undeniable truth is beaten into their thick skulls. Not surprisingly, it sticks. Now, there are indisputable facts —such as the sun rises in the east and sets in the west —but there are also silly half-truths, like you should wait 30 minutes to swim after eating. The real danger for investors is when a universally accepted exaggeration is narrow-mindedly applied in portfolios. In fact, expectations for future earnings, not the actual results, are the real catalyst for stock price changes.
Investors certainly aren’t behaving like earnings results are the only thing that matters for stocks. Instead, they are obsessed with what the Federal Reserve (Fed) will say or do next about interest rates, the hot-and-cold US-China trade negotiations and whether the isolationist US President Donald Trump will finally overcome his butterflies and deliver a military strike on an antagonistic Iran that is just itching for a fight.
As analysts sharpen their pencils to further refine 2020 earnings estimates, markets are at a curious inflection point. Recent factor (i.e., from momentum to value) and style (i.e., from growth to value) shifts have complicated the outlook. Investors are struggling to decide if this is a more permanent change in leadership or just another head fake in a long line of head fakes.
What is clear is that over the past few years, an unusual pattern has emerged, revealing a disconnect between corporate earnings and stock price changes —challenging the belief that corporate earnings drive stock prices. US stocks have rallied sharply this year because investors expect that an eventual US-China trade deal combined with a more dovish Fed will lead to a noticeable bump in future earnings. So, it follows that evolving changes in 2021 earnings expectations will likely determine what investors should expect from stock prices in 2020. Let’s take a peek.
Do As I Say and Not As I Do
Over the past several decades, investors have spent an extraordinary amount of time and money trying to forecast both actual earnings results and surprises. Today, earnings models remain a staple of many fundamental and quantitative investment approaches. The widespread popularity of earnings models strongly indicates that investors have an unwavering belief that earnings are a key factor in the future direction of stock prices. But is this faith in earnings supported by the results?
In their book, The End of Accounting and the Path Forward for Investors and Managers, Baruch Lev and Feng Gu demonstrate that meeting the consensus estimate doesn’t result in any share price change, while beating consensus expectations earns you an underwhelming 0.5% increase. They find that missing the consensus estimate, a catastrophe that some corporate executives will do almost anything to avoid, will, on average, drop the share price by an average of 1–1.5%, a typical daily price move.
Although quarterly earnings announcements used to be major events for investors, Lev and Gu claim that “in the last two to three decades, due to accounting regulators’ sins of omission and commission, reported earnings lost their usefulness to investors.”1 Even if you knew at the beginning of each quarter with 100% accuracy which companies would meet and/or beat their earnings estimates and bought the winners three months ahead of the earnings release date and sold them after the release, the average gain from a 3-month investment was 6% (annualized 25%) in 1989 to 1991. Today, it’s less than 2%. Remember, these 2% gains are reached through perfect foresight —and since no earnings model would achieve 100% accuracy, the researchers report that investors would receive “only a tiny fraction of this gain, namely close to zero.”
Investors may have already reached the same conclusion regarding the usefulness of earnings models. As of September 23, the health care sector has the third-highest earnings-per-share (EPS) growth forecast of the 11 economic sectors for the third quarter. Meanwhile, the technology sector has the second-worst EPS growth forecast. Recently, analysts have also been increasing their EPS estimates for the health care sector. Lastly, of all the sectors, health care has the strongest 1-month and 3-month EPS estimates upgrade-to-downgrade ratios.
What’s the reward for all these solid third-quarter earnings expectations for the health care sector? As of September 23, it’s the worst-performing sector year to date. And, you guessed it, technology is the best-performing sector. In addition, as of September 23, investors have withdrawn $4.5 billion from health care sector ETFs while adding $1.7 billion to technology sector ETFs.
If earnings were the primary driver of stock returns, investors should expect much better performance and flows from the health care sector. So, what gives? Despite the solid and improving fundamentals picture for health care, investors remain concerned that political wrangling in 2020 will be a headwind for the sector. Until investors receive greater clarity on the outcome of the 2020 election, I expect health care sector performance to be volatile.
This underscores that expectations, not actual results, matter most and will inform our outlook for 2020 stock market returns.
Patterns, Patterns Everywhere
So far this year, the S&P 500 Index has climbed slightly more than 21% —a fantastic return for investors. However, according to FactSet, earnings for S&P 500 companies are expected to decline 3.7% year over year through the third quarter. If earnings do fall year over year in the third quarter, it would mark the third consecutive quarter of declines. This would be the first threequarters earnings decline for the S&P 500 Index since the fourth quarter 2015 through second quarter 2016, further confirming the so-called earnings recession. Strangely, earnings for S&P 500 companies rose by more than 20% in 2018, yet the index fell by about 4.5% for the year. What’s going on here? Is this just more evidence that actual earnings results don’t matter much for stock price changes?
It’s always been about evolving expectations, and investor behavior reflects that reality. The declining effectiveness of earnings models, the odd response to solid earnings from the health care sector and recent years’ stock market performance confirm it. In 2017, the S&P 500 Index returned nearly 22% because investors correctly anticipated a big jump in 2018 earnings from the huge fiscal policy package delivered by the Trump administration that year. And, earnings did rise more than 20% in 2018. Not surprisingly, stocks fell in 2018 as investors realized that 2019 earnings would be negatively impacted by temporary fiscal stimulus benefits, the Fed raising rates, rising trade tensions with China and tough year-over-year earnings comparisons. That brings us to 2019, and stocks have performed well thus far. Investors expect that a US-China trade deal, a more dovish Fed and easier year-over-year earnings comparisons will result in double-digit earnings growth in 2020.
Taking my simple logic and carrying it forward to the outlook for stocks next year, stock market performance will largely depend on changing earnings expectations for 2021. After what is expected to be a solid year for earnings in 2020, the risks to 2021 earnings are likely skewed to the downside.
A number of items on the horizon could cloud the outlook. Similar to 2016, the uncertain outcome of the 2020 election will likely pose a headwind for stocks until at least November. It’s difficult to handicap the outcome of US-China trade negotiations. And if a deal is reached, the benefits may be short lived. The recent Fed meeting indicates that they may not deliver as many rate cuts as investors were expecting in the coming months. As you might expect at this point in an unusually long economic expansion, the pace of jobs growth has slowed. If the US consumer, the workhorse of the economy, begins to feel the pinch of a weakening labor market that has almost nowhere to go but down, that may hurt 2021 earnings results, too. Lastly, should 2020 earnings rebound by the double-digit growth that many analysts are forecasting, it will make it all the more difficult to top those solid numbers in 2021.
Of course, there are many things that could result in much better-than-anticipated earnings in 2021. But with many folks penciling in a US recession that year, I think the odds of disappointment are greater. And if the pattern of the past few years holds, it may be tough going for stocks in 2020.
1 Baruch Lev, “Forget the Consensus Estimate: Quarterly Earnings Don’t Matter Much Anymore,” Lev End of Accounting Blog, April 21, 2017.
Earnings Per Share
The monetary value of earnings per outstanding share of common stock for a company.
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.
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