The wrong question — and the right one — to ask about earnings headwinds💬
Why expected earnings can rise despite bad news 📈
Something extraordinary happened during the first three months of the year: Analysts revised up their forecasts for S&P 500 earnings.
According to FactSet, analysts currently expect the S&P 500 to earn $228.43 per share. This is 2% higher than the $223.43 expected as of December 31, 2021.
Some of this can be explained by analysts fine-tuning their financial models, which initially may have relied more heavily on guesswork.
Nevertheless, the revisions are pretty surprising considering risks that emerged during the period.1
The question we usually ask
When a new headwind emerges, investors probably think to themselves: How will this hurt the earnings2 of the companies I’m invested in?
Geopolitical turmoil is negative for sentiment for most people, so sales should suffer. Persistent supply chain disruptions are a double whammy since they put a cap on sales while causing more inflation. Higher-than-expected inflation means higher costs of goods, so gross profit margins should shrink. Rising labor costs should pressure operating profit margins. The Fed raising interest rates means financing costs should rise.
These were among the unfavorable developments from the past three months. And yet expected earnings have been revised up.
The problem is we’re asking the wrong question.
The question we should ask
The right question is: Can the companies I’m invested in deliver on earnings?3
It’s similar to the question above, but it broadens the scope of the inquiry to consider more than just the negative impacts of just the unfavorable developments.
Specifically, this question forces you to consider the possibility that earnings may even go unaffected, something that’s proven to be the case during the pandemic. If there’s one thing we all should’ve learned over the past two years, it’s that consumers and businesses are incredibly resilient and remarkably adaptable.
Despite hits to sentiment, consumers have continued to demonstrate a willingness to spend. Among other things, this can be explained by relatively healthy finances, bolstered by $2.5 trillion in excess savings. Also, U.S. employers added 1.7 million jobs in 2022 so far; that’s a lot of new income that previously wasn’t being earned.
Despite rising costs, businesses have demonstrated an ability to maintain and even increase profitability. They’ve been raising prices, cutting costs, leveraging their operating structures, and investing in productivity-enhancing technology.
It’s never ceteris paribus
As a thought exercise, it can be useful to consider how a new challenge could affect the earnings of a business, ceteris paribus — Latin for “all other things being equal.”
But all other things are never equal.
The onset of the pandemic was the end of business as usual. Everyone has had a unique experience with this. Many have found themselves working differently or just flat out doing different work.
In 2020, I worked at Yahoo Finance, which produced eight hours of live programming five days a week from a studio. When everyone was sent home for public health reasons, we were no longer able to use the studio. Did that business get shut down? No. Over the period of 48 hours, managers and producers scrambled to set up a virtual studio while getting on-air talent the critical tools they needed to broadcast from home. It wasn’t a perfect tradeoff, but the live programming never had to go dark.
Businesses will make adjustments in the face of new challenges. This is especially the case for publicly-traded corporations with executives who have to answer to shareholders who demand earnings growth no matter what. Leaders will seek out ways to keep business humming because it’s written into their personal goals, which are in line with the team’s key performance indicators, which in turn are in line with the company’s objectives and key results.
And at the end of the day, the most critical result is always earnings growth. Everyone’s employment status and compensation will be tied to it in one way or another. That’s because earnings pay for dividends and drive up stock prices — two things shareholders care about most.
Another important factor in all of this is emergency monetary and fiscal measures. Say what you want about what the government should and shouldn’t do during crises. But the Federal Reserve and Congress play a massive role in propping up the economy. That’s just American capitalism for you, and it plays a significant role in whether a company can deliver on earnings.
The bottom line: Bad news will emerge, but you shouldn’t expect businesses to just take the L. They’ll make changes to keep profitability up while being mindful of the resilience of their customers and support of their government.
More from TKer:
📉 Stocks fall: The S&P 500 fell 1.3% last week. It’s now up 9.1% from its February 24 low of 4,114, but still down 6.8% from its January 4 high of 4,818. For more on big rallies amid market down turns, read this and this.
🙋🏻♀️ Gender diversity is bullish: From BofA Global Research: “There is a strong link between gender diversity and financial results. [Return on equity] has been higher for companies with over 25% female execs (compared to rest of S&P 500) in 8 of the past 10 years. And, gender diversity has signaled lower earnings risk.“
🚨 Economic recession and bear market warnings: Deutsche Bank economists expect the U.S. economy to go into recession within the next two years. For more on this, read this.
🧳 No sign of recession in jobs: Unemployment lines are getting shorter. The number of American workers filing initial claims for unemployment benefits fell to 166,000 during the week ending April 2, 2022. This is the lowest level since November 1968. For more on the labor market, read this.
📈 No sign of recession in services: Two separate surveys confirmed that service sector activity growth accelerated in March. The S&P Global U.S. Services PMI jumped to 58.0, with new business expansion accelerating to its fastest pace since June 2021. Meanwhile, the ISM Services PMI rose to 58.3, driven by gains in employment and new orders. From S&P Global’s Chris Williamson: “Business activity in the vast service sector enjoyed a boost from the relaxation of virus-fighting restrictions in March, regaining strong momentum after the Omicron-induced slowdown seen at the start of the year. Demand for services is in fact growing so fast that companies are increasingly struggling to keep pace with customer orders, leading to the largest rise in backlogs of work recorded since the survey began in 2009.“ For more on strength in the services industry, read this.
🛳 No sign of recession on cruises: From Carnival Cruise Line on Monday: “Carnival Cruise Line said today that the one-week period of March 28-April 3 was its busiest booking week in the company's history, showing a double-digit increase from the previous record 7-day booking total.“ For more on people doing stuff, read this.
⚠️…it’s worth noting that recessions start when things are good. The question is whether we’re near that peak in growth where economic activity inflects for the worse. For more on why the economy can keep growing, read this.
🏛 Fed details tightening plans: On Wednesday, the Federal Reserve published the minutes of its March policy meeting, which included details on how the central bank planned unwind the emergency actions it took during the pandemic. From Bloomberg: “The Federal Reserve signaled it will reduce its massive bond holdings at a maximum pace of $95 billion a month, further tightening credit across the economy as the central bank raises interest rates to cool the hottest inflation in four decades.”
🍔 Food prices rise: From Bloomberg: “The war has wreaked havoc on supply chains in the crucial Black Sea breadbasket region, upending global trade flows and fueling panic about shortages of key staples such as wheat and cooking oils. That’s sent food prices — which were already surging before the conflict started — to a record, with a United Nations’ index of world costs soaring another 13% last month.“
🚗 Used car prices fall: From Manheim Consulting: “Wholesale used-vehicle prices (on a mix-, mileage-, and seasonally adjusted basis) declined 3.3% in March from February. The Manheim Used Vehicle Value Index declined to 223.5, which was up 24.8% from a year ago.“
Up the road 🛣
Earnings season kicks off this week as the nation’s biggest banks announcing their Q1 financial results. JPMorgan Chase announces on Wednesday morning. Citi, Wells Fargo, Goldman Sachs, and Morgan Stanley announce on Thursday morning. Investors will be listening carefully to see how business has been affected by the various risks that emerged during the period.
The March consumer price index report will be published on Tuesday. Economists expect inflation to be high with CPI jumping 8.4% year-over-year. Excluding food and energy, prices are expected to have been up 6.5%.
The March retail sales report comes on Thursday. All eyes will be on any negative impacts resulting from deteriorating consumer sentiment caused by persistently high inflation and the war in Ukraine. Economists expect sales to have climbed by 0.5% from February.
The U.S. stock market will be closed on Friday, April 15 for Good Friday.
Geopolitical angst spiked in February with Russia’s invasion of Ukraine. The conflict sent global food and energy prices surging. Inflation was already hot with the consumer price index jumping 7.9% year-over-year in February, the biggest increase since January 1982. Meanwhile, the Federal Reserve recently raised interest rates for the first time since 2018 in its ongoing effort to cool prices. And the central bank’s members have only been getting more hawkish in their tone.
That’s because earnings are the most important driver of stock prices. For more on this, read this.