Time to Prepare for Fourth Quarter 2021 Results
With the S&P 500 (NYSEARCA: SPY) With the fourth quarter earnings cycle having already started, it’s time to prepare for the peak of the season. The peak is still a few weeks away, but you better be prepared. So far reports of names like Oracle (NYSE: ORCL) and Broadcom (NASDAQ: AVGO) suggest a good quarter of reporting for the tech sector, but things might not be so strong for other sectors. In our view, supply chain worries, inventory and rising inflation are going to be the dominant theme again, the question is whether the average S&P 500 company will be able to weather the challenges and with what type of margin?
The S&P 500 beat earnings growth consensus 3,000 basis points on average in H2 2020 and H1 2021, but that number is on the decline. The average S&P 500 company broke a much lower 1,200 basis points margin in Q3 and we believe it could be even lower in Q4. Not only are the economic momentum running out of steam, inflation continues to weigh on the bottom line of many companies and there is only a certain amount of inflation that the consumer can handle. Retail figures already suggest that higher prices reduce volume and that is a very bad thing for the economy. If higher prices reduced sales, the results could be mixed in terms of expected revenue and profit.
Profit growth will slow in Q4
Profit growth is slowing from the high pace of 90% set in the 2nd quarter of calendar year 2021 to just 21.2% in the 4th. Assuming the market beats consensus by the same margin as in Q3, this still represents a deceleration of over 50%, which is not positive for price action. The analyst’s consensus estimate of growth has trended steadily at this level, which is also worth noting as the estimate has tended to increase in each of the previous four quarters. We see this as a sign of uncertainty among analysts and a sign that opens the door to unexpected events, be it a failure or a beat, and each could be quite important. Based on the latest inflation data, however, we are leaning towards “weaker than expected” for many sectors, including consumer discretionary.
Looking ahead, the outlook is for more of the same. Annualized growth will slow to just 9.0% in 2022, from more than 45% in 2021, with weaker results in the first half of the year. The consensus on earnings growth in Q1 2022 is only 6.0% against 21.2% in the 4th and then falls to 3.9% only for Q2 2022. These, like the estimate for the Q4 2021, move steadily to the side and don’t offer much confidence at the moment.
The sectors with the highest growth expectations are …
The sectors with the highest growth expectations in this reporting cycle are energy, materials and industrial products. The energy sector, in particular, is worth getting involved simply because of the price of oil. Oil prices are down from their recent high but remain double what they were at the end of last year and are trading at 3 year highs, so we believe energy companies are about to declare windfall profits. Industry and materials are also expected to do well due to economic reopening, the resumption of long-shelved projects and general economic activity.
The technical outlook: the S&P is ripe for a correction
The S&P 500 is ripe for a correction simply because of valuations. The average company is trading at over 21 times its forward earnings and well above the 5 and 10 year averages. The catch is that profits continue to rise and the trend is still up, so it can be difficult to plan for a correction. It looks like at least a small correction is forming now and if it does, the index could drop below the 4,500 mark. In this scenario, the index’s next support target is near the level of 4,300 where we would expect to find much stronger support. If the index manages to regain a foothold at or above the 4,500 mark, we could see sideways trading until the peak of the reporting season begins. In either case, we see a pullback in index prices, especially a major correction, as a welcome entry point. Profit growth slows, it does not disappear, and the economic outlook remains positive if overshadowed by inflation.