The recent pullback in the S&P 500 has deflated the forward P/E to 20.1 as of close last Thursday, which is in the bottom of the post-COVID Crash recovery range. The P/E derating is not surprising as bond yields have risen to put downward pressure on P/E ratios.
What’s next? The upcoming Q3 earnings season will be a test for both bulls and bears. The key question for investors is whether the E in the forward P/E ratio rises fast enough to support stock prices and offset rising rates?
A mixed picture
Wall Street earnings estimate revisions present a mixed picture. S&P 500 EPS estimates had declined for two weeks in a row, though a more updated report from FactSet
shows upward revisions in the following week. By contrast, estimates for both the mid-cap S&P 400 and small-cap S&P 600 show strong positive momentum.
The weakness in S&P 500 revisions may be attributable to USD strength. Large-cap companies tend to have more foreign operations and their sales and earnings are more sensitive to currency fluctuations.
That said, the S&P 500 has exhibited an uneven correlation with the USD Index in the last 10 years. The USD is a safe haven currency and can experience fund flows during both risk-on and risk-off periods, but relative growth and interest rates are also important factors in determining currency levels.
A detailed estimate revision analysis
The Street is entering the Q3 earnings season on a fairly upbeat note. FactSet
reported that Q3 2021 is the fifth consecutive quarter that analysts have shown positive estimate revisions.
In more normal times, company analysts tend to be overly optimistic. They initially post high estimates and gradually revise them down as the reporting period approaches, according to FactSet:
In a typical quarter, analysts usually reduce earnings estimates during the quarter. During the past five years (20 quarters), the average decline in the bottom-up EPS estimate during a quarter has been 2.9%. During the past ten years, (40 quarters), the average decline in the bottom-up EPS estimate during a quarter has been 3.7%. During the past fifteen years, (60 quarters), the average decline in the bottom-up EPS estimate during a quarter has been 4.9%.
To be sure, the rate of revisions has decelerated. The monthly analysis of quarterly estimate revisions shows a gradual downward trajectory for Q3 earnings. The key question for investors is whether expectations are too rosy.
The bottom-up view
On the other hand, the bottom-up view from companies is still upbeat. The rate of positive to negative guidance is still positive, which is contrary to the historical record of the preponderance of negative guidance.
However, the macro summary from The Transcript, which monitors and summarizes earnings calls, sounded a cautionary note about supply chain bottlenecks..
Inflation and supply chain challenges continue to be the most prominent economic theme. It doesn’t appear that supply chain challenges are getting any better.
The previous week’s earnings calls had similar warnings, though it was more upbeat about the waning effects of the pandemic.
Economic weakness driven by the Delta variant appears to have been short-lived. While growth may have slowed some from the euphoric pace earlier this year, the economy continues to benefit from high consumer demand. Supply chain disruptions are not getting better though and inflation is likely to last into next year. The FOMC met last week and decided to keep monetary policy unchanged. However, Jerome Powell was relatively direct in saying that tapering is likely to start at the next meeting.
Where does that leave us? I am cautiously bullish as we enter the Q3 earnings season. Expectations are high but history shows that companies have guided sales and earnings estimates to slightly beat them. The bulls will say that the guidance rate remains positive and the macro environment supportive. The bears will say that the rate of positive estimate revisions has been falling, which is a sign of deceleration.
The reporting calendar is very light this week and the Q3 earnings season is to begin in earnest next week. The coming month will be a crucial period to determining the direction of stock prices.