Profit Rebound Ripe For Sector ETFs

Earnings are the lifeblood of the equity market. Stocks can whipsaw up and down based on a lot of factors in the short term (GameStop, anyone?), but over the long term, the ultimate driver of share prices is cold hard profit.

That’s why investors are paying close attention to the deluge of corporate earnings reports that are hitting the market now and over the next few weeks.

The financial report cards now reflect the performance of business in the fourth quarter, a period that was tainted by the pandemic. The final figures are still pending, but preliminary data from FactSet suggests that the profits of S&P 500 companies may have dropped by 4.7% year-over-year in the quarter—the fourth straight quarter of declines.

Worst Earnings Decline Since 2008

That caps off a dismal year in which earnings declined by more than 12%, the first noteworthy decline since the financial crisis (profits dipped just a hair from 2014 to 2015).

Yet even as the COVID-19 pandemic decimated many industries, its damage wasn’t evenly spread. Within the S&P 500, four of 11 sectors actually managed to eke out growth. Earnings for utilities, consumer staples, technology and health care may have grown by 1.9%, 3.8%, 5.6% and 10.8%, respectively, in 2020 (again, final figures still pending).

It’s not hard to understand why these sectors were so resilient. As has been widely reported, tech companies have been major beneficiaries of the stay-at-home pandemic environment; health care firms have been instrumental in finding coronavirus treatments and vaccines; and utilities/consumer staples provide must-have products and services that are largely insulated from economic volatility.

2021 Outlook

After a rough 2020, earnings are expected to rebound in 2021, though much uncertainty remains over how strong the recovery will be.

Analysts expect some of the sectors that struggled the most last year to have the biggest recoveries. The S&P 500 as a whole is anticipated to see earnings growth of 22.6%, more than recovering all of 2020’s decline. If analysts are correct, earnings per share in 2021 will be 4% higher than in 2019.

At the sector level, analysts expect the energy sector to go from a net loss to a profit. At the same time, industrials, consumer discretionary and materials may grow their profits by 73.4%, 59.7% and 32.4%, respectively—all faster than the market as a whole.

All of the other sectors are projected to grow slower than the broad market, but some of them—like the aforementioned tech, consumer staples, health care and utilities sectors—are growing off a higher base since they managed to increase their earnings in 2020.

Earnings/Price Relationship

I started this piece by saying that earnings are the lifeblood of the stock market—and that’s true. Earnings are the No. 1 driver of stock performance over the long term. But shorter term, there can be a disconnect between stock prices and earnings.

Multiples—the amount investors are willing to pay for a given amount of earnings—can go up and down significantly for all sorts of reasons, and their movement often overwhelms any change in profits. For example, in 2020, tech earnings jumped 10.8%, but tech socks surged 43.6% as multiples expanded.

On the other hand, utilities’ profits increased by 1.9% in 2020, but share prices only rose by 0.6%, resulting in modest multiple compression for the sector.

*FactSet estimates

The same can be true in 2021. Energy, industrials and consumer discretionary stocks may not be the best-performing sectors of the year. Perhaps their growth is already priced in; or investors don’t anticipate the growth to last; or they just aren’t willing to pay up for the growth due to various factors (energy’s regulatory pressures come to mind).

Yes, over the long term, earnings are the primary driver of stocks, but that says nothing about the short term.

Email Sumit Roy at [email protected] or follow him on Twitter @sumitroy2