The market faces a tough bar this earnings season: the combination of all-time high prices and very high expectations.
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“Peak growth” has become the latest boogeyman in markets. That’s the buzzy phrase used nowadays in discussing the rate of change in corporate earnings, U.S. gross domestic product, stock prices, government and central-bank stimulus, and inflation. It’s the trend that matters for investors, and the outlook is moving toward a deceleration on several of those fronts.
It’s a recognition that the easy money has long ago been made in the postpandemic bull run, and that markets and the economy are entering more uncertain, midcycle times. That has pushed quality stocks back into favor, while kicking some of the recent quarters’ biggest winners to the curb. Economically sensitive S&P 500 energy stocks, for example, have dropped into correction territory since June, as has Cathie Wood’s speculative-growth-heavy ARK Innovation exchange-traded fund (ticker: ARKK). Market breadth has narrowed as a smaller group of winners—such as the Big Tech stars—have kept indexes aloft.
As for the Dow Jones Industrial Average this past week, the index fell 182.31 points, or 0.52%, to 34,687.85. The S&P 500 slipped 0.97%, to 4327.16, and the Nasdaq Composite shed 1.87%, to 14,427.24. Each still finished within a couple of percentage points of its record high. Treasury yields rose, then fell, with the 10-year note’s yield jumping above 1.4% after Tuesday’s release of the latest hot inflation data, then dropping back to 1.3% to end the week lower than it started. The curve flattened as shorter-term rates held their ground.
The dynamic suggests a summer lull after an eventful year, as the market, policy, and the economy transitions to their next phases.
Second-quarter earnings season should reinforce that narrative. S&P 500 earnings per share are expected to soar 62% from a year ago, per data from Yardeni Research. That’s gangbusters growth. But investors know it’s coming. Stocks have rallied to their record highs and rich multiples this year in expectation of a postpandemic rebound that’s now showing up in the numbers. It follows 48% EPS growth in the first quarter and expectations of 23% and 17% jumps in the third and fourth quarters. In other words, peak earnings growth is here.
The result is that the market faces a tough bar this earnings season: the combination of all-time high prices and very high expectations. Stocks will get punished if they disappoint and won’t be rewarded if they simply meet expectations. Big banks and other financials kicked things off this past week, and they exceeded earnings expectations by about 26% on aggregate. But their shares nearly universally sold off: Goldman Sachs Group (GS), JPMorgan Chase (JPM), and Bank of America (BAC) beat forecasts and traded down immediately after.
The coming weeks should bring a lot of negative reactions to great but expected earnings—as well as management commentary about the margin-challenging impact of inflation in the coming quarter.
The first official estimate of second-quarter U.S. GDP is due at the end of July. Much like earnings, it’s forecast to be a blockbuster rate of growth—but the peak for this economic cycle. Economist consensus calls for a seasonally adjusted annual growth rate of 9.5% in the April-June period, after a 6.4% pace in the first quarter. Following China, which reported a decelerating GDP growth rate this past week, the U.S. economy could see its expansion cool in the second half. Still great growth, but less great.
Inflation and the Federal Reserve’s next move, meanwhile, remain a source of uncertainty. “Inflation has increased notably and will likely remain elevated in coming months before moderating,” Fed Chairman Jerome Powell confidently told Congress this past week. He reiterated the central bank’s sanguine take on inflation being a temporary side effect of the economic reopening under way.
Nonetheless, a 5.4% year-over-year rise in the June consumer-price index raised some eyebrows this past week. A majority of the increase in prices came from new and used cars, out-of-town lodging, and airfares—all of which can be reasonably expected to ease as the reopening sorts itself out. But wages and primary housing costs also rose, which are seen as stickier forms of inflation.
“The bad news is that we are still not out of the woods, as [inflation measures] are likely to remain elevated through year end and into early 2022,” wrote BofA Securities economists this past week. “The good news is that we are likely near the peak, at least for the next few months, as base effects are less favorable and shortage pressures rotate away from goods towards services.”
The focus on bond-purchase tapering and interest-rate hikes will only become more salient in the months ahead. The Fed’s rate-setting committee’s next meeting will be on July 27-28, followed by its annual Jackson Hole, Wyo., policy symposium a month later and another FOMC meeting three weeks after that. One of those will almost certainly serve as the forum for the unveiling of the Fed’s tapering timeline, which could begin in late 2021 or early 2022.
Put it all together, and the most attractive stocks in the coming months should be those of companies that can control their own destiny without needing to rely on the rising-tide-lifts-all-boats tailwind of the rapid postpandemic recovery—and can withstand the negative impacts of hot inflation and shifting monetary policy.
“This is about quality, predictability, and safety,” says Robert Phipps, director at Per Stirling Capital Management. “The next few months are going to really reward those dull and boring stocks at the expense of almost everything else in the market.”
Phipps points to Big Tech stocks like Apple (AAPL), Alphabet (GOOGL), and Facebook (FB) as beneficiaries of such an environment. They’re proven long-term growers with steep profit margins. Each has less reliance on the economic backdrop than cyclicals and cheaper relative valuations than many other buzzy software stocks.
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Alphabet also makes a screen of quality companies with defensive attributes and stronger-than-average earnings trends run by Morgan Stanley strategists this past week. Costco Wholesale (COST), Altria Group (MO), CVS Health (CVS), and Amgen (AMGN) also make the list.
The U.S. economy isn’t on the brink of a recession, and third-quarter earnings growth will still be plenty strong. But it’s the trend that matters, and investors are never content with what they have. It can’t hurt to stick to quality while the market figures out what comes next.
Write to Nicholas Jasinski at [email protected]
