The stock market has rallied nearly xx% in the second quarter of the year. However, don’t expect the upcoming corporate earnings season to paint an equally rosy picture.
Expectations are for Q2 corporate earnings to be the worst in more than 10 years. It dates back to the depths of the financial crisis.
Adding to the uncertainty for investors, a significant number of companies have withdrawn their guidance – including almost a third of S&P 500 companies – and many more have yet to provide quarterly updates ahead of their scheduled earnings release.
“There’s a deficit of information that needs to be filled at some point,” said Sebastien Leburn, senior portfolio manager at Boston Private, during an interview with MarketWatch.
A Possible Disconnect from Reality?
That means investors will only be able to start matching up actual corporate performance with the stock performance on the earnings call. That could lead to some massive repricing if the stock prices have disconnected from reality.
“That’s why I think earnings will be very important, because they’ll provide a dose of reality,” said Brad Cornell, professor emeritus of finance at UCLA. “They are going to tell us exactly whether a company is on a path that justifies this run-up.”
“It’s all about clarity and having some guidance,” said Boston Private’s Leburn. “Without that, you have nothing to work with.”
Particularly worrisome are the expectations for year-over-year growth estimates for earnings per share. On March 31, expectations were for an 11.1% decline in EPS growth during Q2.
As of yesterday morning, that decline in EPS growth has ballooned to a -44.6%, according to FactSet data. That would be the largest decline in earnings since the fourth quarter of 2008. In that year, earnings fell 70% in the depth of the financial crisis.
Somehow, this massive decline in EPS growth since the end of Q1 has coincided with the stock market rallying xx%. This provided bearish investors with more proof that a detachment exits between the markets and reality.
The Rally’s Vulnerability
The stock market rally could be particularly vulnerable should just one or two of the larger S&P 500 companies post disappointing numbers.
Just five companies now make up more than 20% of the index. These include Apple Inc., Microsoft Corp., Amazon.com Inc., Google parent Alphabet Inc., and Facebook Inc. Additionally, a poor earnings report from any one of those companies could drag the index down. It can even bring the rally to a grinding halt.
It’s unlikely that one of those five companies will decide to “kitchen sink” the quarter. However, you can expect many companies to take advantage of the pandemic to flush all the bad news, bad ideas, and bad decisions out at once.
“Second-quarter earnings will likely be a ‘kitchen sink’ report from many companies,” said Marc Lichtenfeld, chief income strategist with the Oxford Club, an independent investment newsletter publisher. “They can throw in all of their write-offs and other expenses and know they will likely be forgiven for an earnings miss due to the extenuating circumstances.”
Most importantly, investors need to view corporate performance and stock performance as two completely separate indicators of a company’s overall health.
James Gellert, CEO of Rapid Ratings, a data and analytics company that assesses the financial health of private and public companies, says “Nobody should equate strength in the S&P 500 with underlying corporate strength.”
Buckle up, the next few weeks could be a bumpy ride.