Earnings season is a crucial time for equity investors during turbulent economic periods. For the past three months, news about corporate financial performance has trickled out to the public, but the deluge of earnings results will shed light on how the economy has progressed through the summer.
COVID-19 has created general uncertainty and instigated rapid shifts in behavior among consumers and producers, but it's not yet clear how the disruption will influence the business cycle or permanently alter the economy. Any indication that a return to normal is still distant or altogether unlikely is very relevant to investors, who should be following up on the major trends from earlier this year.
Q2 was horrible but better than expected
The second quarter was characterized by drastic reductions in S&P earnings year-over-year but also widespread results that exceeded gloomy analyst expectations. Companies in the S&P 500 delivered profits that were 30% lower year over year, according to Factset. Conditions were certainly challenging, which warrants concern in a changing stock market. However, 84% of the index's members exceeded analyst earnings estimates. Investors already expected borderline catastrophic results, which we can assume were reflected in share prices. This was the rare occurrence of bad news that was actually good.
If third-quarter results show further improving conditions, the economy might be in position to sustain its long expansionary trend after a relatively brief shock. Alternatively, deepening struggles would point to systemic issues that could take years to fully overcome. A comparative look across sectors and review of bellwether stocks is very important.
Early signs are encouraging
As of Oct. 26, just over one-third of S&P 500 constituents had reported quarterly results, and 70% of those delivered revenue and earnings that topped analysts' estimates. That's excellent early news on the heels of the better-than-expected profits from three months earlier.
Importantly, management guidance on earnings was disproportionately bullish relative to consensus forecasts, indicating that the management teams who are tracking data across different sectors of the economy are mostly expecting decent operating conditions.
Banks tell a mixed but overall positive story
The major banks were the first large industry group to report. Banking results are informative, because these companies facilitate business activity in every other part of the economy. Default risk from distressed industries, declines in lending demand, or abandonment of business combinations would all signal an economy that is shifting from expansion to contraction. Low interest rates create challenges for consumer and corporate banking operations, whereas a drop in merger and acquisition (M&A) activity is an issue for investment banks, so earnings in the financial sector are relevant to tracking overall corporate performance.
The major banks generally met or exceeded expectations, led by Goldman Sachs (NYSE:GS), which delivered EPS nearly 75% above consensus estimates due to strong contributions from security trading activities. Banks with disproportionately large exposure to consumer lending were somewhat weaker than their investment-banking-heavy counterparts. It's hard to panic about these profits, but investors should recognize that pent-up M&A demand and asset volatility were important performance drivers, while activities that support fundamental activities of productivity and consumption were headwinds.
Look for other sector-specific trends
Technology, materials, healthcare, and industrials performed the best relative to expectations, though results still suffered in difficult conditions. Investors should check on bellwether stocks in these sectors to assess the continuation of trends across the economy.
Important industrial companies Caterpillar (NYSE:CAT) and 3M (NYSE:MMM) reported steep drops in both sales and profits, but both notched sequential improvements, exceeded analyst estimates by a significant margin, and maintained a positive tone for the rest of the year. These aren't great signs from an overall economic perspective, but it seems that the damage inflicted will be less severe than initially feared.
Healthcare giant Johnson & Johnson (NYSE:JNJ) had an even more encouraging report with a 4% contraction in medical device sales far outpacing the 10% to 25% downside that management had previously forecast. Investors will want to see elective procedure volumes rising, which should be reflected in device, equipment, and care provider earnings. A return to normal for healthcare outside of COVID-19 treatments will go a long way in stabilizing the sector, which is a major employer.
Finally, the tech sector represents an interesting case in that it led the 2020 bull charge with swelling valuations. Many tech companies were less affected by COVID-19, while the likes of e-commerce, work-from-home, and digital security companies actually benefited from the new conditions. Investors should ensure that fundamental improvements earlier this year were not one-time gains that will dissipate as the economy normalizes, and stocks across the sector will have to deliver results to justify their lofty valuations.
Overall, investors should stay apprised of corporate results in these uncertain times. Allocations should reflect an outlook for 2021 with conditions that should be challenging but far from a doomsday scenario. Investors would also be wise to assess the risks and opportunities associated with potentially permanent changes to e-commerce, work-from-home, and demand for office real estate. The third quarter is yielding some great insight into all of the above.