Good morning, VettaFi Voices! Third-quarter earnings announcements have almost come and gone, with yesterday being the last big burst of companies. Some key firms have yet to announce, like Nvidia and Walmart, but everything I’m seeing says it surpassed expectations. Last quarter, Todd Rosenbluth said that the strength of earnings mainly came from cost cutting rather than revenue growth. I’m asking the wider team: Have things changed? What stood out to you? Where is the real strength in this go-round of earnings?
An Earnings Season Roundup
Todd Rosenbluth, VettaFi head of research: FactSet published a commentary last week. For Q3 2023 (with 81% of S&P 500 companies reporting actual results), 82% of S&P 500 companies have reported a positive EPS surprise, and 62% of S&P 500 companies have reported a positive revenue surprise.
For Q3 2023, the blended (year-over-year) earnings growth rate for the S&P 500 is 3.7%. If 3.7% is the actual growth rate, it will mark the first quarter of year-over-year earnings growth reported by the index since Q3 2022. But they also point out that earnings have not been a driver of stock prices this time around.
Companies that beat earnings rose modestly the next couple of days. But companies like Tesla that missed expectations got crushed. On October 18, the company reported actual (non-GAAP) EPS of $0.66 for Q3, which was below the mean (non-GAAP) EPS estimate of $0.70. From October 16 to October 20, the stock price for Tesla decreased by 16.5%.
Eight of the 11 S&P 500 sectors are reporting year-over-year earnings growth, led by the communication services, consumer discretionary, and financials sectors. The largest sector ETFs here are the Communication Services Select Sector SPDR Fund (XLC), the Consumer Discretionary Select Sector SPDR Fund (XLY), and the Financial Select Sector SPDR Fund (XLF).
The sectors are reporting a year-over-year decline in earnings are energy, healthcare, and materials. The Energy Select Sector SPDR Fund (XLE) tracks the S&P 500 Energy sector. VettaFi’s Head of Energy Research Stacey Morris can speak to this topic better than me. MLP securities are found in the Alerian MLP ETF (AMLP) but are not part of the S&P 500.
Looking at Energy Infrastructure Earnings
Stacey Morris, VettaFi head of energy research: Broadly, weaker energy sector earnings are a function of lower oil and natural gas prices this year relative to 2022. Recall that energy had an extremely strong 2022 from both an earnings and equity performance perspective.
The beauty of energy infrastructure corporations and MLPs is that their cash flows do not fluctuate as much with commodity prices, because they predominantly provide services for fees. For midstream, 3Q earnings were generally strong, with several examples of companies beating expectations and raising guidance for the year. We continued to see positive dividend trends for midstream.
Results from the broader energy sector were arguably more mixed. For example, ConocoPhillips had a solid quarter, whereas Chevron disappointed and fell 6.7% on the day of its announcement. MLPs are up nicely this year, while the default energy investments like XLE, Exxon, and Chevron are all down.
Rosenbluth: Before going deeper, I want to highlight the WisdomTree U.S. Large-Cap Fund (EPS). First off, great ticker! The large-cap ETF is earnings-weighted, not market-cap-weighted (or equally weighted). Alphabet has a higher weighting than Microsoft, for example. Meanwhile, Exxon Mobil is a top-five holding, even though it is not a top-10 position in the SPDR S&P 500 ETF Trust (SPY).
Fewer companies are beating on the top line, with 62% having higher revenues than forecast. Cost cutting remains a driver of EPS like it did in the past.
However, according to FactSet, analysts are expecting 12% earnings growth for calendar 2024. If this occurs, growth stocks are likely to be in focus. Those are found in ETFs like the Vanguard Growth ETF (VUG), the iShares Russell 1000 Growth ETF (IWF), and the SPDR Portfolio S&P 500 Growth ETF (SPYG).
Jane Edmondson, VettaFi head of thematic strategy: I think one of the notable aspects of this earnings season has been that the tech sector of the S&P 500 has resumed its growth trajectory. Of the 73% of tech companies that have reported, Q3 earnings are on track to increase over 20%.
Tech has resumed its Q1 status as the growth driver for the market, thanks to strong results from the “magnificent Seven” stocks, with Apple perhaps the outlier as it is underperforming.
There is a new ETF (or rather a repackaged ETF) that used to trade under the ticker BIGT that is focused on the Magnificent Seven stocks from Roundhill — the Roundill Magnificent Seven ETF (MAGS). This is another ETF within the new trend of Micro Basket themes.
Rosenbluth: I did not realize it changed tickers. I knew and liked the ticker BIGT. I’m a 6′ man named Todd after all!
Edmondson: Big Todd, of course! It changed to the new ticker on November 9, so it’s hot off the press.
Rosenbluth: So now the ticker BIGT is available — as is TODD or JANE. But I digress!
Stacey brings up a good point about the dividend growth trends. Much of the year I have been focused on quality ETFs like the iShares MSCI USA Quality Factor ETF (QUAL), the Pacer US Cash Cows 100 ETF (COWZ), the VictoryShares Free Cash Flow ETF (VFLO), the Astoria US Quality Kings ETF (ROE), etc.
I’m doing a webcast later today with Amplify discussing the Amplify Cash Flow High Income ETF (HCOW). I heard VettaFi Financial Futurist Dave Nadig on ETF Prime this week talking about ROE. Strong earnings are of course needed to generate the free cash flow to pay dividends.
Banking Stocks Coming Back
Edmondson: The financial sector has positively surprised this quarter with the biggest actual earnings relative to estimates. It does appear that the banking sector is adjusting to the higher-for-longer environment.
Edmondson: The earnings fundamentals at least suggest some sort of recovery in the banking sector since the Q1 banking debacle.
XLF is now positive over the last six months, up 4.22%, and the Vanguard Financials ETF (VFH) has a positive return of over 6% for the last six months. The Invesco KBW Bank ETF (KBWB) is up almost 4% on a six-month basis.
Am I experiencing recency bias?
Jen Nash, VettaFi economic and market research analyst: Todd talked about a rosy outlook for earnings for 2024. I wanted to highlight some recent economic data that is notable and could impact this.
The ISM Manufacturing PMI has now contracted for 12 straight months, while the S&P Manufacturing PMI only recently stabilized after contracting for several months. Additionally, both the consumer confidence and consumer sentiment indexes have fallen for three straight months.
However, it’s worth mentioning that although consumers are reporting that they are feeling less optimistic and more cautious, their behavior tells another story. Consumers are still fueling the economy with retail sales growing for the past six months and real GDP increasing to 4.9% in Q3, largely because of consumer spending. Will consumers be able to continue?
Job growth and wage growth are slowing, unemployment is rising, and savings are dwindling. It is more likely than not that the spending spree won’t be sustainable. But as we’ve heard countless times this year, “Don’t bet against the American consumer.”
Consumer Habits Changing
Edmondson: I just wrote an article about the prospects for the holiday shopping season, with the National Retail Federation projecting retail sales growth of 3%-4% expected, with 7%-9% growth in digital commerce. Cost-conscious consumers are still expected to shop, but the majority of the spend will be online.
There are lots of ways to play the bifurcation of retail favoring digital commerce. The Amplify Online Retail ETF (IBUY), the ProShares Online Retail ETF (ONLN), and the Global X E-commerce ETF (EBIZ) are all focused on online retailers, with IBUY also including online travel and omnichannel retail.
According to a consumer survey by CommerceHub, nearly 80% of respondents plan to do all or most of their holiday shopping online this season.
That begs the question, what other “sweet spots” of consumer spending are we seeing more broadly?
Roxanna Islam, VettaFi head of sector & industry research: I’ve mentioned before all the issues with lofty expectations. It’s almost impossible to expect revenue to grow infinitely.
You’d have to pass on costs to customers. And if you’re dealing with retail customers, that’s not going to last in this environment. That’s why cost cuts have been easier — from a stock market perspective, it doesn’t usually matter too much how you grow earnings. But cost cutting also has its issues, because you’re taking that cost away from somewhere — you’re either reducing your marketing expenses, or cutting employee pay, or diminishing service levels.
None of this is really good enough long term unless you make other operational changes, but it’s sometimes good enough to satisfy analysts/investors and get a good stock price reaction.
Earnings Expectations in the Future
I think we’ll have to see a reset in earnings expectations over the next few quarters, which has started to happen especially with many companies reporting lower earnings from lower consumer demand. Now a lot of earnings is priced in and stock prices react more on future guidance and forward outlook.
Edmondson: This has been a big year for things like travel and music concerts. I think they call it “funflation.”
The MUSQ Global Industry Music ETF (MUSQ) is a good play on the “Swift Effect” with exposure to companies like LiveNation the owner of Ticketmaster, and Vivid Seats, and the Sphere property Las Vegas.
Consumers are selectively willing to pay up for experiences.
Islam: Part of it is still the catchup from COVID, I think. Several of my favorite bands came to my area in 2023 after not coming for several years (especially the European ones who had to cancel their world tours due to extended COVID restrictions overseas). I feel like this has been the best year for concerts for me. I definitely paid more than I should have but made sacrifices elsewhere to spend that money. A lot of people did the same.
Edmondson: I agree, Roxanna, that consumers are willing to cut in other areas to fund FUN.
Rosenbluth: I walked away from the water cooler and think the earnings discussion shifted. Online shopping and bands are more fun than the movement of stocks of companies that missed EPS expectations.
Edmondson: Looking ahead to Q4, I wonder if earnings expectations are too optimistic or pessimistic? Last year, going into Q1, everyone was expecting a recession. Expectations have shifted on the prospects for a recession next year. I’m still hearing soft-landing prognostications. And lately I have been reading notes about deflation.
Deflation Has Some Benefits
Heather Bell, VettaFi managing editor: How likely do you think that is, Jane? I’ve seen that word used a lot lately when talking about China, but how would it change the picture in the U.S.?
Edmondson: There was a note out today by Kristina Hooper with Invesco about the “disinflation train.” Her argument is that global central banks are pumping the brakes and letting rates flow through the system.
She said it a lot better than I just did, but she claims that Europe, Canada, and the U.S. appear to be experiencing deflation.
The eurozone composite Purchasing Managers’ Index (PMI) for October clocked in at 46.5, which is down from 47.2 in September, suggesting the economy weakened further at the start of the fourth quarter after contracting in the third quarter. And the flash estimate of eurozone inflation for October fell to 2.9% year over year from 4.3% in September.
The Canada jobs report supported the view that the Canadian economy is also cooling. And of course in the U.S., the jobs report showed lower job creation of 150,000 in October ,with September non-farm payrolls revised downward.
And Todd, you mentioned the U.S. PMI, which is below 50, standing at 46.7 in October. If central banks are comfortable with these trends, and oil prices come in a little bit, there could be a real relief rally. That is maybe what the market has been responding to this last week, along with some better-than-expected earnings reports.
As the end of rate hikes approaches, the risk on “all clear” signal could be sounding. And what about bitcoin? It is at $37,000!
Impact on Earnings
Bell: Any thoughts on how deflation would affect earnings going forward? What industries would it hurt the most?
Edmondson: We already see energy prices retreating, but obviously there are geopolitical issues in play there with tensions in the Middle East. If rates stabilize, that would be great for the housing market and housing inflation. And lower rates would be a boon for the consumer as well.
Deflation is a strange thing. If you look at the solar industry, with ETF exposure like the Invesco Solar ETF (TAN), it has been hard hit as demand for solar has been hurt by higher interest rates. But if panel prices deflate and come down enough, that could re-spur demand. I think the same argument could be made for electric vehicles. If prices align in parity with gas-powered vehicles, demand will shift in favor of EVs. Price is not the only consideration in purchasing an auto — infrastructure and battery life are a big deal as well for consumers, as are the variety of vehicles on the market.
But lower prices, combined with interest rate stabilization, could reignite demand in areas of the economy where price was becoming a barrier to growth.
Rosenbluth: I’m back after the cash flow webcast to come back to the initial topic — earnings. If you own an equity ETF that is not just broad market exposure, earnings trends matter, and so does how the market absorbs those earnings and guidance. Disney reported results and is up 6% as I type this due to what seems like strong cost-cutting efforts. Disney is approximately 5% of XLC based on its market cap and 4% in the more narrowly constructed Invesco NASDAQ Internet ETF (PNQI). It has a roughly 1% stake in the iShares S&P 500 Value ETF (IVE).
The Pitfalls of Cost Cutting
Islam: That’s a good example of what I was referring to earlier, though. Streaming companies thrive on investing in new content, and Disney is cutting spending, including $3 billion in content spending (especially with the strikes)? That seems like a short-term bandage. It’s good for stock prices in the short term, but maybe questionable in long term.
But to Todd’s point, earnings can matter even more if you’re looking at an ETF that invests in a specific industry or theme. Then earnings can sometimes have broader readthroughs for peers and could see a wider boost across several names.
Edmondson: If you look at the Disney quarter, the shining star was ESPN and not theme parks. ESPN is the No. 1 brand on TIkTok. I think that is fascinating!
The way the consumer is engaging with brands is transforming before our eyes!
Key Earnings Stats & AI
Zeno Mercer, VettaFi senior research analyst: It’s a very fair assessment that EPS growth is outpacing sales growth and that much of this across the board has come from extraordinary cost cutting or preserving measures. You do have areas that are seeing price increases and pricing power holding strong and up-sells of high-margin products that are also pushing top and bottom line further.
Nothing in life is guaranteed, but something nearly certain is we’ll continue to see companies utilizing AI and robotics to improve operational efficiencies, whether we see growth or decline in GDP. As of November 8, we had 41 of 62 companies in the ROBO Global Artificial Intelligence ETF (THNQ) reporting, seeing weighted average sales growth of 12% year over year for Q3 and 45.5% earnings growth with 93% profitable (positive EPS). These firms exhibited an average revenue surprise of 1.9% and an average EPS surprise of 18%. Roughly 58%-60% beat expectations and ~8% missed expectations.
The biggest positive beats were from Alteryx (+10% revenue beat, 344% EPS beat), Spotify (+247% earnings beat), JFrog (+58% EPS beat), and Cloudflare (+61% EPS Beat). So far, THNQ has seen weighted average upward revisions to EPS of 4% over the past 30 days for 2023 and +4.6% for 2024. Meanwhile, sales projections remain essentially unchanged. For 2024, THNQ is slated to see growth of 14.8% revenue and 23% EPS, according to FactSet consensus.
AI’s Problem-Solving Potential
One angle of improving operations for more physical-forward companies (not digital-first) is further implementation of robotics and automation solutions, from planning to ongoing operational efficiencies.
As an example, I just got back from the Rockwell Automation Analyst Day in Boston. They are the largest pure-play industrial automation company, employing 26,000, and focus cross-industry in areas such as general manufacturing (autos and energy transition), semiconductors, as well as healthcare (think scaling GLP-1 production). Every second counts, and there is a labor shortage that is expected to persist effectively indefinitely until automation is able to solve for more areas here.
Rosenbluth: Artificial intelligence has been driving earnings this year for megacap tech and so much more. VettaFi is the index provider behind THNQ
Edmondson: And technology like robotics, automation, and AI will be deflationary forces at work as well.
Mercer: Overall, we expect a lot of projects to really ramp up and get back into growth in 2024 across these areas, supported by government-backed initiatives such as the CHIPS Act, the Inflation Reduction Act, and the Infrastructure Law. Lower energy costs not only impact transportation, but also ongoing operations of manufacturing and warehouses that have more automation elements.
Macrowise, I certainly hope we see collective deflation across real estate costs (both on a personal level and for North America). The rent is too dang high and eating into spending other places.
Certainly, I’m expecting costs to go down over time as we see higher efficiency across all sectors. At least, theoretically, we’ll be approaching higher utility and efficacy per unit of work.
Edmondson: OK, we called it! Earnings season is nearing its end and the “deflation train” is coming to save the day!
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