Schwab Sector Views: The Earnings Recession Has Ended
The economic recovery began last spring, but the COVID-19 corporate profits recession is just now coming to an end.
As the fourth-quarter 2020 earnings reporting season draws to a close, the vast majority of companies across the equity sectors have beaten analysts’ expectations by a large margin. While sectors like Consumer Discretionary, Communication Services, and Information Technology can be thanked for the impressive results, the Financials sector has become one of the dominant forces. I believe this could continue, for reasons I’ll discuss below. Meanwhile, rising forward earnings expectations have kept lofty valuations in check, particularly for Financials and Health Care, which I also continue to favor.
Earnings growth has recovered from COVID-19
While S&P 500® index earnings were sharply lower in 2020 in the aftermath of the COVID-19 crisis, they made an impressive comeback in the fourth quarter, nearly matching year-ago results. The unparalleled stimulus and speed of the economic recovery boosted analysts’ expectations throughout the year. However, with nearly two-thirds of the S&P 500 companies having released Q4 2020 financial results so far, 80% have beat even their relatively optimistic earnings outlooks. This compares with a 70% average beat rate going back to 2013.
Earnings growth returned to positive territory in Q4
Source: SCFR, Yardeni.com as of 2/8/2021. Chart reflects year-over-year quarterly earnings growth for the S&P 500 Index. Past performance is no guarantee of future results.
The percentage of positive surprises has been strong, as has the degree by which earnings beat expectations. In part, this reflects the highly uncertain economic environment that led many companies to withdraw their earnings and revenue guidance. Nevertheless, as can be seen in the table below, most of the sectors have contributed to positive surprises, exceeding earnings expectations by a healthy 19%, on average.
Earnings surprises have been surprisingly strong
Source: SCFR, Bloomberg as of 2/8/2021. Positive Surprise is the percentage of earnings reports that exceeded analysts’ consensus expectations. Earnings Surprise is the average percent by which actual earnings exceeded expectations. Earnings growth is the average quarterly year-over-year change in earnings per share. The Energy sector’s Earnings Surprise bar is truncated for chart size reasons.
While the earnings results have been broadly positive, it’s the behemoths in many of the sectors that have moved the dial the most. The Consumer Discretionary sector was a significant contributor to upside surprises after internet retailing giant Amazon announced that earnings-per-share (EPS) beat estimates by 192%, with earnings up 64% and revenues jumping 44% year over year, due to strong growth in online Amazon Prime sales and Amazon Web Services profits. Meanwhile, Tesla missed estimates by 22%, but posted 86% jump in year-over-year EPS. This more than offset the sharp losses within the hotel, restaurant and leisure industry, which saw revenues fall 50% on average.
Communications Services sector giant Facebook announced earnings growth of 52%, north of the consensus estimate by 20%, on strong ad revenues. Likewise, Alphabet (parent of Google) posted Q4 EPS growth of 45%, besting expectations by 43%.
The Information Technology sector has seen broad participation in the Q4 earnings season, with more than 90% of the companies beating expectations, but it was again the mega caps Apple and Microsoft that led performance. Apple reported earnings that surprised by 18.3%, with EPS growing 34% on strong high-end iPhone sales. Microsoft reported EPS that rose 34% year-over-year, beating estimates by 24%, on increasing demand for web cloud services and the work-from-home boom in laptop and gaming sales.
Another big surprise has come from the Financials sector, where earnings are up 18% on average, and 86% of earnings reports so far have exceeded estimates by nearly 35% on average. While some financial companies have credited higher-than-expected trading revenues, many of the biggest banks have said lower-than-expected loan defaults are allowing them to reverse expenses charged earlier in the year as loan loss reserves. This trend may continue amid additional stimulus out of Washington and broader distribution of the COVID-19 vaccines, which likely will continue to bolster sharp improvements in consumer and business credit conditions.
Bank earnings and loan loss reserves
Source: SCFR, Bloomberg as of 2/8/2021. S&P 500 Index Financials earnings per share, diluted. Loan Loss Reserves to Total Loans as reported by JPMorgan Chase & Co. For illustrative purposes, only data from the largest U.S. bank by market capitalization was used. The next three largest banks (Bank of America Corp, Wells Fargo & Co., and Citibank Inc.) also reported reductions in Loan Loss Reserves to Total Loans.
While the Financials sector accounts for only about 10% of the market cap in the S&P 500 index, it’s notable that it is estimated to have contributed 20% of the total earnings in Q4 2020. As the largest sector of the market and a net beneficiary of the COVID-19 crisis, Information Technology is unsurprisingly expected to be the largest contributor once the 4Q earnings season concludes.
Sector contribution to S&P 500 index earnings
Source: SCFR, Bloomberg as of 1/31/2021. Earnings contribution is the percent of total S&P 500 index earnings by each sector, and is compared to the sector weight (market capitalization) of each sector as a percent of the S&P 500 index.
Like the Financials sector, Health Care also has contributed significantly to overall earnings. With steady-Eddie revenue and earnings trends, earnings have beat analysts’ estimates by a modest margin (about 7%), but those trends have remained solidly positive, with earnings growth of 15% in Q4. In fact, Health Care was one of the sectors least affected by the COVID-19 crisis in terms of earnings growth, which was down just 2% in the second quarter of 2020. I like the Health Care sector for many reasons, but some that stand out include its relative immunity to crises, steady and moderately strong earnings growth, and attractive valuations (more on this below).
Momentum in future earnings expectations
Along with the economy, earnings for the overall equity market are quickly recovering from the crisis, and the rising trend through the end of 2020 is likely to have legs well into 2021. Revisions in analysts’ earnings estimates—both the direction and magnitude—can provide a read on relative earnings momentum across the sectors. Like price momentum, these revisions can be slow to react to changes in direction of actual earnings. But once a trend is established, they can be decent signals as to which sector might outperform in the coming months. As you can see in the chart below, the Financials and Energy sectors have the highest positive earnings revision rates. This is consistent with the rotation that we’ve been seeing in the markets recently, with Financials and Energy among the best-performing sectors over the past three months. On the flip side, Utilities and Consumer Staples—which saw the slowest upward revisions—have been the worst performers.
Three-month change in earnings estimates and total return
Source: SCFR, Bloomberg as of 2/8/2021. 3-month percent change of Bloomberg analysts’ consensus earnings estimates (BEst) and the total return of the S&P 500 Index and sectors. *BEst bar for the Energy sector is truncated from 99%, for chart size purposes.
Forward-looking valuations have leveled off
To be sure, valuations in general are lofty. The massive run-up in stocks since the market lows last March has pushed trailing 12-month price/earnings ratios (P/Es) to levels even higher than was seen in the late-90’s tech bubble. But keep in mind when hearing about the sky-high trailing P/Es that the markets are forward-looking, so a comparison to forward earnings expectations can provide a better sense of valuations. Currently, they are below the tech-bubble highs, and have leveled off as upward earnings revisions have kept up with the gains in stocks—as can be seen with the flattening trend in the forward P/Es since last July.
Trailing and forward P/E ratios
Source: SCFR, Bloomberg as of 2/5/2021.
At the sector level, using mix of trailing and forward-looking valuations makes sense, as well. But judging valuations across sectors can be like comparing apples to oranges.
Let’s use the common “value” and “growth” equity-style categories to explain what I mean. When we talk about value sectors (like Financials and Energy), we’re usually referring to those sectors that have attractive valuations relative to the overall market by a number of metrics: price to earnings, price to book, enterprise value to earnings, etc. Growth sectors typically have higher valuations relative to the broad market, because they are characteristically priced high in anticipation of better-than-average future revenue and earnings growth. So, to compare attractive valuations of the Financials sector (value) to the Information Technology Sector (growth) in absolute terms is not very useful. You would expect to see higher valuations in Technology, based on their higher projected growth.
One way to make them comparable is to evaluate each sector’s current valuation metric against their respective historical average and variability. This is called a Z-score, and it measures the number of standard deviations away from the mean. For example, let’s say Information Technology has a valuation Z-score of 3.17 and the Financials sector’s valuation Z-score is 0.46—as represented in the chart below. They are both expensive from a historical perspective relative to their own history, but Financials has a lower Z-score and is more attractive relative to Information Technology. The chart below shows a compilation of numerous forward and trailing valuation metrics, such as dividend yield, price-to-earnings, and price-to-cash flow, among others. From them, we can see that Financials and Health Care—the two sectors that I think will outperform the overall market in the near term—are both attractive relative to most other sectors.
S&P 500 Index sector valuations
Source: SCFR, Bloomberg as of 1/31/2021. Bars represent value composites that include six different valuation metrics that provide a holistic perspective on current valuations relative to each of the sectors’ own historical valuations, as well as relative to the other sectors.
While the Energy sector also looks very attractive, I assess these composite valuation measures in the context of many other considerations—such as the macroeconomic environment, fundamentals and behavioral factors (momentum, sentiment, etc.), as well as geopolitics. The Energy sector still faces heightened uncertainties, such as regulatory and OPEC supply risks—both of which are difficult to assess currently. On the other end of the spectrum, Information Technology and Consumer Discretionary are relatively expensive. Yet these sectors have many other factors going for them—so I currently have them rated as “marketperform.”
For more in-depth rationale of my views on all 11 S&P 500 sectors, visit Sector Views and Schwab Sector Insights: A View on 11 Equity Sectors. There I provide a summary and lists of pros, cons, and risks for each sector.
Keep in mind that no matter what our view is on any of the sectors, remaining diversified is very important. Concentrating in too few sectors can dramatically affect the risk profile and performance of your portfolio. So, if you do make any sector tilts in your portfolio, keeping them small is a good way to maintain appropriate diversification and potentially enhance the performance of your portfolio.
What do the ratings mean?
The sectors we analyze are from the widely recognized Global Industry Classification Standard (GICS®) groupings. After a review of risks and opportunities, we give each stock sector one of the following ratings:
- Outperform: likely to perform better than the broader stock market*
- Underperform: likely to perform worse than the broader stock market
- Marketperform: likely to track the broader stock market
* As represented by the S&P 500 index
Want to learn more about a specific sector? Visit “Schwab Sector Insights: A View on 11 Equity Sectors” to learn more about each sector and see how they compare. Schwab clients can log in to see our top-rated stocks in each sector.
How should I use Schwab Sector Views?
Investors should generally be well-diversified across all stock market sectors. You can use the Standard & Poor's 500® Index allocations to each sector, listed in the chart above, as a guideline.
Investors who want to make tactical shifts in their portfolios can use Schwab Sector Views' outperform, underperform and marketperform ratings as a resource. These ratings can be helpful in evaluating and monitoring the domestic equity portion of your portfolio.
Schwab Sector Views can also be useful in identifying stocks by sector for potential purchase or sale. Clients can use the Portfolio Checkup tool to help ascertain and manage sector allocations. When it's time to make adjustments, Schwab clients can use the Stock Screener or Mutual Fund Screener to help identify buy or sell candidates in particular sectors. Schwab Equity Ratings also can provide an objective and powerful approach for helping you select and monitor stocks.