Back with a bang: US fourth-quarter earnings turn positive


The big news from the fourth-quarter reporting season is that earnings growth is back. Consensus expectations for were for further contractions in corporate earnings, but instead we’ve seen an expansion – in the US at least.

Now that most of S&P 500’s constituents have reported, some 83% have surprised positively – well above the historical average. And these beats have been big: 17% higher than expectations on average.

Most strikingly, these surprises came after several weeks of analyst upgrades in the run-up to the announcements. After earnings contracted by less than expected in the second and third quarters of last year, analysts raised their fourth-quarter forecasts. But companies still managed to beat those elevated expectations.

It’s worth stressing that this is not the norm. Analysts generally revise their expectations down ahead of earnings announcements, which makes it easier for companies to achieve positive surprises.

What we’ve seen this time is a consistent pattern of companies beating elevated earnings expectations. This is highly unusual, but it’s not unique.

A cyclical resurgence

What we’ve seen this time is a consistent pattern of companies beating elevated earnings expectations. This is highly unusual, but it’s not unique. We saw the same phenomenon during the recovery from the global financial crisis in 2009 and again in 2017, when the Trump tax cuts in the US coincided with synchronised stimulus measures worldwide. Given those precedents, we can conclude that this is not merely a blip but a real improvement in corporate fundamentals. Earnings growth is back with a bang.

For now, this phenomenon is most prominent in the US. But where it leads, the rest of the developed world follows. And while many technology companies have continued to benefit from lockdown, there have been notably strong releases from cyclical companies, including banks and industrials.

In the former category, Goldman Sachs, Bank of America, JP Morgan Chase and Morgan Stanley have beaten expectations handsomely. Their profits have been boosted by strong trading activity but also the unwinding of last year’s bad-loan provisions, which proved too pessimistic. Among industrials, Fastenal, which distributes tools and safety equipment, delivered better-than-expected earnings, indicating increased activity in the construction sector. Transportation companies have done well too, including logistics firm JB Hunt and railroad operators CSX and Union Pacific. All of this points to a robust economic recovery.

A busy year for buybacks

Companies have also started buying back their own shares with gusto. A combination of cheap credit and resurgent corporate confidence made this the strongest January for buybacks ever. According to estimates from Goldman Sachs, 2021 looks set to be the third-busiest year for buybacks since 2007, after the record levels of 2018 and 2019.

So, while companies have still been guarded in their outlooks and guidance, their actions indicate considerable confidence. Some of these buybacks are coming from highly cash-generative tech companies but cyclicals have joined in too. The banks, for instance, have been announcing buybacks up to their regulatory limits.

A much-improved outlook

At start of the year, we thought that we’d see a 10% contraction in earnings in Q4. But now, after a flat 2019 and a big decline in the first three quarters of 2020, it’s clear that earnings are turning positive again. With continuous positive revisions to analysts’ earnings forecasts, sequential improvement in quarterly announcements and positive surprises during this reporting season, everything points to an economic recovery.

How long will it be before we’re back where we were before Covid? We should expect it to take several quarters at least. The historical average for recovering lost growth is 10 quarters, but it should be quicker this time, given the sudden cessation of economic activity during lockdowns and the potential for a sharp rebound. In any case, we look set for several quarters of very strong profit growth.

Why is the market so muted?

Despite all this, the stock-market reaction has been lacklustre. Shares in companies that beat expectations in both revenue and earnings per share have underperformed the market by a percentage point rather than outperforming by the historical average of 1.5 percentage points.

Why? Well, it’s largely because investor confidence improved so much in the run-up to the reporting season. After all, investors have already absorbed two previous quarters of positive earnings surprises and a great deal of welcome news: fiscal stimulus in the US, the development of several effective Covid vaccines and the start of mass inoculation in the developed world.

As a result, profit expectations are the now the best they’ve been since February 2002. So despite the very real improvement in corporate fundamentals, the share-price reaction has been unexciting. One notable exception was Netflix – but the after-hours surge in its shares appears to have come in response to its mooted buybacks rather than the earnings themselves.

What happens next?

The most important takeaway for investors is the likelihood of a sustained earnings recovery. While reality has now caught up with expectations, several quarters of earnings growth should boost sentiment and returns still further.

So far, much of the earnings recovery has been concentrated in growth stocks – specifically the tech stocks that have benefited from lockdown. There is still a question mark over the likes of Netflix, however, which may have been ‘pulling subscribers from the future’. If so, their growth may have peaked during the pandemic. Meanwhile, earnings forecasts are highest for areas in which earnings were, in some cases, entirely wiped out last year. If current forecasts are accurate, it’s these unloved areas – value, cyclical and UK stocks – that look best positioned over the next few quarters as growth bounces back.

View Article – published by Aberdeen Standard Investments on 12th February 2021