Halfway through earnings season, the ‘peak everything’ story may need to be put on hold

We’re halfway through second-quarter earnings. The results not only continue to beat forecasts by a wide margin, but estimates for the third and fourth quarter — and now even for 2022 — are continuing to rise.

And most say estimates are still too low.

Q2 earnings and revenues: a blowout
(Year-over-year)

Earnings: up 86% (highest since Q4 2009)
Revenues: up 21% (a record)

Source: Refinitiv

As has been the case for the last several quarters, analysts have substantially underestimated the extent of the economic recovery. Earnings are coming in 18% above expectations, well above the historic norms of 3% to 5% above expectations.

Why does this keep happening? Analysts have consistently underestimated the extent of the recovery, and the extent of corporate profits, for several quarters in a row. Why can’t they get it right?

“The analysts cover individual companies; they’re not economists,” Nick Raich from The Earnings Scout told me. “They have been looking to the companies for guidance, and the company guidance overall has been far too conservative. The expectations for the economy keep getting better, not worse.” 

Those higher expectations are being reflected in the revenue numbers as well. Revenues are coming in 4.6% above expectations, four times the historical average of 1.1% above estimates, as CNBC’s Robert Hum reports.

That revenue beat is very important. Raich explains why: “To beat a revenue estimate, you are dealing with an aggregate number that is in dollars, and those dollars are in the billions. When you are in the billions, a 5% beat is huge.” 

The much higher revenues also are supportive of the idea that the economic recovery is stronger than expected.

Peak everything – the belief that economic activity and earnings growth would peak in the second quarter – has been the dominant market narrative for several months. However, indications of economic activity in the second half remain strong, and while earnings growth is not accelerating as much in the second half, analyst again appear to be underestimating the recovery, including into 2022.

 ”The growth estimates for the second half are rising on a daily basis, and the 2022 numbers will likely go up as well. So the estimates are still too low,” Raich said.

S&P 500 earnings
Q3 estimates
Today:  up 28.3%
July 1:   up 24.7%

Q4 estimates
Today:  up 20.3%
July 1:   up 17.3%

Source: Refinitiv

2022 is still many months away, but the magnitude of the recovery is so great that some strategists are already saying the analysts will be wrong again. 

“We think that 2022 estimates… might be too low,” Savita Subramanian, head of U.S. equity and quantitative strategy at Bank of America, said in a recent note to clients. “Why? Three reasons: readings from leading indicators, supportive policy, and vaccination push in Australia, Japan and the developing world.”

The continuing rise in earnings estimates is removing one risk to markets in the second half, but there are others:

Margin erosion. Many companies have reported substantially higher commodity and in some cases labor costs, but most have been able to pass the higher costs on because consumers are flush with cash. S&P profit margins were at 13% in the first quarter, a historic record. They remain just below 13% for the second quarter.

A delta variant outbreak that results in a significant change in economic activity. Traders have been working on the assumption that the delta variant outbreak may slow the recovery but not derail it. In his press conference, Federal Reserve Chair Jerome Powell supported this narrative, noting that the delta variant will have health consequences, but that recent waves have shown less economic impact. “It may be that the effect is to slow the economy down just for a period of months, or not,” he said. “There are many parts of the country where it might not have an effect and we’re just going to have to see what the economic effects are.”

An acceleration in Fed policy around tapering and rate hikes. Powell again insisted that inflation would be “transitory” and pushed back on the notion that a decision had been made on the timing of tapering the Fed’s bond buying program. “We will provide clarity as appropriate on timing, pace and composition… no decisions have been made, and I am not in a position to give you any guidance on timing,” he said.

Many traders are concerned that the very high valuation of the market (more than 20 times 2022 estimates), when combined with typical August to October seasonal weakness, may be the greatest risk to the market near-term.

Some pointed to Apple’s earnings report, which was a blowout by every metric, yet the stock ended down 1.7% on heavy volume. Apple is trading at 25 times 2022 earnings, above the 15 to 20 times forward numbers for the past several years.

Facebook, in its earnings report, also noted decelerating earnings growth.

Alec Young at Tactical Alpha admits that valuations are high but he isn’t buying an imminent downturn. ”Peak everything is a big deal, but the peak may be a little farther out than we thought,” Alec Young told me.

“Apple can still grind higher, and so can all of these mega-cap tech names,” he said. “The valuations are high, but they are not outrageous.”