Investors were nervous entering the Q3 reporting season given the plethora of rising headline concerns – rising input costs, supply shortages, an energy price spike, U.S. political deadlock, etc. The chart below breaks down by sector the U.S. company earnings reported so far. On Oct 1st expected Q3 earnings growth was +29%, it currently stands at +35%. Higher earnings are also broad based on a sector perspective which is quite remarkable given that the U.S. economy slowed down in Q3 to only +2% real GDP growth.
Source: Strategas Research Partners
The table below similarly reports the declared earnings for European companies. The Q3 results season have begun on a strong footing with the reported EPS growth rate at +43% versus initial expectations of +35%. Banks, Technology and Health Care industries have recorded the strongest outperformances, while Utilities and Consumer Staples are coming slightly short of expectations. Excluding Commodities and Transportation, both of which are recovering from extreme poor earnings last year, Banks are accounting for 72% of the positive change in Q3 earnings expectations.
Source: Bloomberg Finance
The magnitude, breadth and quality of earnings growth cannot be ignored. The chart below shows that the percentage of companies beating estimates remains at historically record levels despite the short-term headwinds of slower economic growth. Estimated operating margins continue to march higher, reaching 17.4% (another record high) and exhibiting no signs of an imminent reversal. As has been mentioned many times, equities tend not to get into too much trouble as long as margins are not rolling over. Thus far, this does not appear to be a concern.
Source: Strategas Research Partners
Despite the quality of earnings, companies in general are not being rewarded (in the short-term) to the same degree for beating estimates as they are punished for missing. The chart below measures the one-day performance relative to the market after reporting. Companies beating on both eps and sales are only performing in line with the market while misses (on any metric) are leading to short-term relative underperformance. There can be many reasons for this investor behaviour. It can point increased investor nervousness that increases the desire to lock in existing returns amid concerns over future uncertainty. Another explanation is that in some cases earnings beats are still not matching the embedded expectations of lofty valuations.
Source: Strategas Research Partners
In our last weekly update, we did mention the extreme valuation dispersion that characterizes the current market and did say we would go into some detail on where we are finding the greatest mispricings that should allow for above average portfolio returns. On a sector level, investor behaviour towards the Technology sector (largest weight in the Growth segment of the market) and Financials (largest weight in the Value segment of the market) are creating attractive investment opportunities. The flows into Financials remain muted despite the improved stock performance, and valuations, particularly in Europe, remain close to historic lows. Tech valuations, on the other hand, are close to historic highs. Breadth of performance of U.S. Tech stocks remain fine but has been deteriorating of late. Currently just over 70% of Tech stocks remain in positive long-term trends. Not bad, but the chart below shows a remarkable 100% reading for U.S. Banks on this measure.
Source: Bloomberg Finance
However, investors do find it difficult to break from a +12-year gameplan in which the purchase of Technology stocks resulted in automatic outperformance regardless of valuation. The chart below shows flows into U.S. Tech remain at historically elevated levels despite the sector underperforming Financials in 2021 and the macro backdrop of improved economic growth and rising interest rates also providing a tailwind for Financial outperformance to continue.
Source: Bloomberg Finance
This bias extends to the analyst community. The chart below shows which market sub-sectors receive the greatest percentage of positive recommendations from financial analysts. Again interestingly, despite the strengthening price trend and fundamental tailwinds of the Financial sector, banks and insurance companies remain unloved. The two largest tech sub-sectors remain at the top. In our view, stretched valuations, extreme investor flows, peak analyst optimism within the context of deteriorating breadth and significantly reduced relative earnings strength and stock performance are not the usual ingredients for continued outperformance.
Source: Strategas Research Partners
We have no wish to knock single stocks but the chart below of Amazon crystalizes the point we are trying to make above. There is no disputing the quality of the company and its remarkable history of strong sales growth. However, a quick glance at the chart below would show that the stock has gone nowhere since the summer of 2020, significantly underperforming the market, while all sixty analysts covering the stock remain at Buy ratings. With an elevated absolute and relative valuation, the law of large numbers starting to impede growth relative to its past, and yet an overwhelming bullish consensus, there are very few investors left to support the stock as its relative performance starts to come back to earth. There are excellent investment opportunities for those willing to deviate from existing consensus and recognize the winds of change that are currently blowing in financial markets.
Source: Bloomberg Finance
