(Bloomberg) – It has been a shock on Wall Street the past few days how much better the world’s biggest companies have been than anyone thought. What the market made of these results was also unexpected. Despite big profit blows, the share price development of the vaunted Faang cohort was mediocre.
On the other hand, that shouldn’t come as a surprise. Thirteen months after the Covid-19 rally, Wall Street researchers focused on the question of when it is worthwhile for investors in the cycle to break away from companies with the highest growth rates. One academic study found that for companies that priced in a lot of profit optimism, paying was one of the worst strategies in the past four decades.
With corporate incomes quickly returning to pre-pandemic levels in the face of the best expansion in a decade, the fastest growers get disrespect. A long-short strategy based on projected income growth for Russell 3000 stocks – buy the top quintile against the lowest – has lost more than 4% this year, down on four of the 17 quantitative styles tracked by Bloomberg behind all four.
Let’s call it the danger of high expectations, a condition that is becoming more relevant today as analysts keep making estimates. Right now, the higher bars are not a hurdle for companies, although negative reactions to gains from stocks like Microsoft Corp., Apple Inc. and Tesla Inc. suggest that a ceiling could be hit after the rally of $ 25 trillion.
“If the blowout results can’t really move things higher, what can and what will?” asked Carter Worth, head of technical analysis at Cornerstone Macro LLC. “What could possibly be said or revealed in the next two to five months that exceeds what has just been revealed? What will advance the market from here? “
In a year when all sales signals were nothing more than a surefire way to lose money, of course, to criticize the current robust expansion is like looking a gift horse in the mouth. Nearly 90% of the S&P 500 companies reported have exceeded analysts’ earnings estimates. This is the strongest reading since Bloomberg started tracking the data in 1993.
Based on reported results and analyst estimates for companies that have not yet released results, first-quarter earnings likely rose 46% year over year, the fastest since 2010, data from Bloomberg Intelligence shows.
But when the story is a guide, putting too much faith in the perceived high growth can be a dangerous game. In a recent update to their paper, entitled Diagnostic Expectations and Stock Returns, researchers such as Pedro Bordalo of Oxford University, Nicola Gennaioli of Bocconi University, Italy, and Rafael La Porta of Brown University found that between 1981 and 2015 most stocks were in place – optimistic long-term earnings growth projections were 12 percentage points per year behind those with the most pessimistic projections.
This is the burden for companies whose stocks have extremely high expectations. A dream that one day they would dominate their industry as Google did in the online search business. It is, of course, a dream that few companies can achieve.
“Over the past 35 years, on average, betting against extreme analyst optimism has been a good idea,” the researchers wrote. “Intuitively, rapid earnings growth predicts future Googles, but not as many as analysts believe.”
While the study focused on individual companies, the concept seems to apply across the board these days, as political support and vaccines raise hopes of a roaring economy. According to Morgan Stanley strategists led by Mike Wilson, the return to normal activity is so optimistic that the market is prone to hiccups such as supply chain disruptions.
“Dreaming of a reopening is easier than actually doing it,” Wilson wrote in a note. “We see growing cost problems in the short term that are not offered at prices. The question also arises of how much pent-up demand actually exists. “
Having gone blind from the pandemic and overly conservative assessments of the earnings power of American companies, analysts are now busy improving their forecasts on one of the fastest clips in years. However, there is a risk hidden in the slope of the yield curve.
Ned Davis Research put the S&P 500’s earnings growth since 1927 in five parentheses and found that, unless it’s really bad – a decline of 25% or more year over year – income growth tends to be inversely related to market returns stands. As the expansion rate topped 20%, as it does now, the S&P 500 rose 2.4% year-on-year, or a quarter of its average return for all periods.
The seemingly strange behavior, according to Ned Davis, founder of his namesake company, has to do with the market’s tendency to always look ahead. And once the good news about earnings is factored in, there’s not much room for stocks to move on.
An example of this is the market performance related to President Donald Trump’s tax cuts. The S&P 500 gained around 20% in 2017 in anticipation of the increase in earnings when the directive came into force the following year. Then came 2018, profits increased and the market fell.
Of course, given the pandemic that is breaking new ground in monetary policy and the economy, nothing in the past may be applicable now. With the S&P 500 trading at 22 times projected earnings and close to its highest multiple since the dotcom era, a moment of reckoning could be approaching.
“The risk in hunting the here and now is that you will pay a premium multiplier for the strength of earnings that the market has been expecting for several months,” said Michael O’Rourke, chief market strategist at JonesTrading. “We can have strong earnings growth and profit blows and continue to hold the market flat or even sell.”
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