Earnings season starts with a rare confluence of bullish factors: stocks at new highs, economic reports exceeding expectations, the vaccine rollout accelerating, an uber-dovish Fed, higher tax fears diminishing, and most importantly, expectations that CEOs will provide far more guidance than they did in 2020.
While CEOs got away with claiming poor visibility and declined to provide guidance last year, that will not work in 2021. Bulls are expecting CEOs to discuss how the reopening of the U.S. economy will be affecting profits, and they are fully expecting that tone to be on the bullish side.
Early signs are encouraging.
Companies are confirming earnings dates and shareholder meetings much earlier than last year. “We take this as a sign that companies have good things to share on their upcoming calls,” Christine Short from Wall Street Horizon said in a note to clients.
Barclays analyst Julian Mitchell reflects the opinion of most strategists: “We expect most companies that have given 2021 guidance to raise it,” he said in a recent note.
When CEOs raise guidance it also causes analysts to raise their own estimates. Some bulls are expecting the current full year S&P 500 earnings estimate of about $175 to move closer to $200. That would be significant: rather than a 25% rise in earnings year-over-year (the best annual growth since 2010), a move toward $200 would be closer to a 40% jump, which would be the largest profit rebound since Refinitiv began keeping records in 2000.
That, bulls say, will justify the current high prices: 2021 earnings at $175 imply a multiple of 23.4, pricey by even bullish standards, but at $200 in earnings the multiple goes to a far more reasonable but still pricey 20.5.
What could go wrong?
What might derail this extremely rosy scenario?
In discussions with analysts and strategists, three issues come up: higher rates, lower margins, and a belief by some that CEOs will start to permanently back away from any kind of short-term numeric guidance.
Higher rates/inflation: Traders will be watching for key inflation metrics like the producer price index and the consumer price index. The market suffered a significant hiccup in mid-February as rates ticked up over inflation concerns. Federal Reserve Chair Jerome Powell has repeatedly emphasized that any pick-up in inflation is likely to be “transitory”.
For the moment, Powell’s message seems to be carrying the day.
“It’s not about inflation, it’s about the Fed’s reaction to inflation,” Alec Young at Tactical Alpha told me. “The Fed has mellowed everyone out. That may be a challenge later in the year, but for now worrying about inflation is not a money-making move.”
But that could change quickly if key inflation data (PPI, CPI) is much higher than expected. Nicholas Colas from DataTrek is one of many who admits this is one of the most difficult issues for the markets to “call” right now: “In the end ‘higher inflation/rates’ is a very real possibility. It has been decades since that was the case, and how badly equity markets respond to this new framework is very hard to predict.”
Lower margins: S&P profit margins — the percentage of sales that turn into profits — have remained high (close to 11%) for several years. But a key aspect of those high margins—controlling costs—has likely become more difficult.
“We know there have been a lot of increases in supply chain prices, and the question is really how much and which companies, which industries will be pushing through increased prices to their consumers,” David Kostin from Goldman Sachs said on our air. He pegged lower margins due to higher costs as a potential factor in 2021 earnings.
Several companies have already reported higher costs—and are indeed raising prices.
Conagra, the maker of Slim Jim, Healthy Choice and Duncan Hines, said it is facing higher material costs, manufacturing expenses, and transportation and logistics costs.
Kimberly-Clark and Smucker’s have already announced higher prices. What’s still unclear is how permanent the higher costs really are, and whether they can be easily passed along to consumers without affecting sales.
Maybe CEOs should stop providing so much guidance?
Some strategists, including Liz Ann Sonders, chief equity strategist at Charles Schwab, have not missed the lack of guidance and are doubtful whether it needs to return.
“I’m not sure we’re going to see a significant surge in companies that re-up precise quarterly guidance,” she said on our air. “Even pre-pandemic, we were on a trend toward companies moving away from quarterly guidance with specificity to analysts.”
She’s right. CEOs do not like to be pinned down around specific earnings metrics, but investors—particularly the active investing set—have become very dependent on that guidance for trading purposes.
So expect an uphill battle to get investors off the guidance merry-go-round.
But Sonders insists that would be the right path: ”I don’t think corporations should run themselves on a quarterly cents-per-share metric, but just in general, the outlook for their business into the latter part of this year and then to look and see what analysts’ reactions are.”