The theme this week is a tough one to figure out, so I’ll spell it out — these are all titles of songs that were hits in 2002. As we work our way through Q1 earnings season, I can’t help but wonder if we’re in the midst of a similar pattern to what went down (no pun intended) in 2002.
At this point, we’re just shy of halfway through earnings reports on S&P 500 companies. And although the numbers haven’t all been rosy, the surprise factor is more positive than expected, with results coming in 8% higher than estimates.
Given that this earnings season brought with it a lot of anticipation for negative results, what’s transpired so far has kept markets afloat for the most part, and offered investors a reason to believe things may not end up as bad as feared.
But are we just prolonging a false sense of optimism? Are earnings coming in better than expected for reasons that can support sustainable and increasing growth? That’s what really matters for investors on the road ahead, and what determines whether these levels of valuations are worth paying. If stocks can produce growth that surprises us, maybe they aren’t as expensive after all.
Yet that 2002 part of the cycle gnaws at me. Earnings growth was far more negative in 2001 and early 2002 than what we’re seeing now. It’s the relationship between the actual outcome vs. what expectations were that’s more similar to today. There was a belief that earnings would improve in the back half of 2002, and they did, but not by as much as the market seemed to expect. In fact, the S&P fell precipitously from the end of Q1 2002 to a new low in October 2002. More importantly, EPS found a bottom 10 months earlier, in December 2001.
We haven’t seen a bottom in earnings yet this cycle, and we sit here today with expectations for a better 2nd half of the year. If the pattern repeats itself and things are not as good as markets expect, a repricing of stocks would be in order. But perhaps later than many of us have called for.
One of the other pieces that gnaws at me about earnings results is the revenue growth. I’ve believed strongly for many months that revenue growth, although seemingly bulletproof, was running a high risk of following inflation down.
Revenue growth for Q1 is expected to come in at roughly 2%, while EPS is expected to be -3% when all is said and done. That tells you revenues aren’t growing fast enough to offset costs, and profit margins are contracting. Yet revenues are still positive in an environment of slowing growth and waning demand. How?
Inflation and pass-through pricing. Whenever and wherever. That’s how.
I posed a question earlier on whether the drivers of earnings can support sustainable and increasing growth. In some cases where companies are growing their market share, increasing unit volumes, or expanding their revenue sources, yes that can absolutely be the case.
But broadly speaking, a common thread this season continues to be revenues buoyed by higher prices. That’s all well and good as long as consumers are still willing to pay for it, but as the months drag on and inflation falls further (as we want it to), and financial conditions stay tight (as we expect them to), I’m willing to bet consumers won’t be feeling so spendy.
The big dilemmas we face as investors are: whether equity markets are complacent or correct, and whether the worst is behind us or yet to come. This is purgatory of the worst kind, in my opinion. The current environment does not suggest we’re through all of the rough patches, and certainly doesn’t suggest early cycle behavior. But the stock market action doesn’t suggest a looming disaster either. It’s as if we’re on a teeter totter that’s holding steady at perfectly horizontal. Sometimes boring is good in markets, but I still believe this part of the boring experience is one that precedes the more volatile, and less complacent, adjustment downward.
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