The market has an earnings problem

·Head of News

Tue, Jul 13, 2021, 2:08 AM2 min read

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Tuesday, July 13, 2021

Huge earnings today don't equal huge returns tomorrow

The second quarter earnings season unofficially kicks off this morning, with Goldman Sachs (GS), JP Morgan (JPM), and PepsiCo (PEP) among the first companies out of the gate.

And as we've chronicled over the last few weeks here at the Morning Brief, expectations have been rising ahead of these results, as analysts struggle to keep pace with the fast-recovering business cycle.

But strong results don't always accompany strong returns. In fact, they often coincide with the opposite.

Year-to-date, "returns in the S&P 500 (+16%) have been entirely driven by rising earnings estimates (+21% YTD)," writes Savita Subramanian, equity strategist at Bank of America Global Research, in a note published Monday.

"But while quarterly earnings surprises and market returns have been correlated (32% since 1996), strong earnings don’t always translate to strong market returns. Historically, 60% of down quarters since 1996 (or 75% of down quarters ex-GFC) occurred in quarters with earnings beats. In 2000, despite earnings beating consensus for 10 straight quarters, the S&P 500 declined for four consecutive quarters." (Emphasis ours.)

In 2020, the market rallied as investors began anticipating robust economic and earnings growth. But the strong earnings we've seen this year — and will see in the coming weeks — serve to validate last year's rally. It may not underwrite further gains in the market.

Earlier this year, the idea of "multiple compression" was a hot one among strategists on Wall Street. The basic argument said that as the economic cycle matured, investors would become less inclined to pay up for additional earnings growth. In other words, any increase in stock prices would need to be accompanied by an even larger increase in earnings growth. A dynamic we've seen this year, as BofA's work shows.

All of which served as another reminder that what drives markets is anticipated — not realized — earnings, and economic growth.

And it's why we had Nick Colas at DataTrek Research in our inbox on Monday morning, writing in the headline of his latest note that "earnings season needs to be awesome." Wall Street analysts think earnings were up 64% over last year, according to FactSet. But these gains have already been factored into stock prices.

What investors need to see to keep pushing stock prices higher, then, is something new to believe in. And that something new will need to be better than consensus expectations.

By Myles Udland, reporter and anchor for Yahoo Finance Live. Follow him at @MylesUdland