The Resilience of Corporate Profitability Has Been a Surprisingly Strong Underpinning for the Equity Markets | ETF Trends

So far, 2021 has been 2020’s saucer of sorts, catching the spillover of the preceding year’s drama and unpredictability. The first seven weeks of this year somehow culminated an exhausting election season with even more spectacle, introduced “Roaring Kitty” and “gamma” to retail investors’ lexicon, and showed that Father Time met his match in one Tom Brady.

However, there has been one fundamental factor building consistent momentum beneath the surface of the markets and headlines over the last several months that also seems to be spilling over into 2021. Corporate profitability is on a phoenix-like return from last spring’s abyss.

The fourth quarter of 2020 was the worst of the pandemic in terms of new cases, hospitalizations, and deaths. The resulting pace of economic recovery slowed as municipalities and individuals reacted to the strain the most recent surge placed on the health care system. Even against that backdrop, the S&P 500 is on pace to report a 2.9% earnings growth rate when compared to the same quarter in 2019, back when “corona” was most likely associated with a beverage, not a pathogen. On the last day of 2020, just seven weeks ago, analysts were expecting a -9.3% decline in earnings for the 4th quarter.

The main driver of the outperformance is also surprising. Corporations have a natural contraction and expansion that coincides with the ebb and flow of the business cycle. When business conditions are positive, companies grow larger and more bloated. As business conditions deteriorate, companies respond by reducing costs and preserving as much of their profits as feasible. Therefore, it may be reasonable to expect any earnings surprise in the 4th quarter was driven by companies keeping costs lower than the market expected. To the contrary, earnings growth in the 4th quarter was not driven by cost reductions alone. S&P 500 companies are on track for revenue growth of 2.8% as well, which demonstrates a source of earnings growth more sustainable than cost reduction.

The momentum of earnings optimism has spilled over into 2021. Even though guidance remains very limited, the small sample of companies that issued guidance for the 1st quarter of 2021 was more positively skewed than average.

The list of macroeconomic risks currently facing the extended risk-on rally is undoubtedly long. Increasing inflation risks, concerning variants of the coronavirus, and lingering monetary and fiscal policy uncertainty are just a few. However, the flexibility of corporations to adapt to a true black swan event that stopped the economy in its tracks for months and still impacts most economic decisions made by businesses and individuals alike only to return to earnings growth about eight months later is truly remarkable. The resulting optimism in fundamentals is understandable and warranted.

In fairness, the expectations for the lack of durability of earnings is usually overly discounted in recessions, but every element of this public health and economic catastrophe, as well as our fiscal, monetary, and medical response, was unimaginable just twelve months ago. As earnings season comes to a close, we feel it worthwhile to recognize that corporate America’s return to growth is one trend from 2020 that we are glad to see spill into 2021.

Source: FactSet, COVID Tracking Project. Data and Analytics provided by FactSet. Author: J. Keith Buchanan, Portfolio Manager – GLOBALT Investments. 

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