As we shift from a nervous week into what could become an earnings cycle filled with tantrums, I find myself buckling in for a historically frustrating season on Wall Street.
After all, investors are clearly reaching for any excuse to sell stocks that a few weeks ago had all the earmarks of being able to support a record-breaking rally. Trouble for China’s overextended lenders is bad . . . for China’s overextended lenders.
We saw Evergrande’s malaise coming years ago. But now the headlines are giving Wall Street a bit of a gut check. Suddenly bad news we all saw coming comes as a shock, while good news earns a yawn.
People looking for disaster will find it in the last place they look. And all we can do is focus past their negativity to pick up the cards they discard along the way.
This shouldn’t be a season that tests our patience. It should be an opportunity to use other investors’ lack of perspective against them.
It all starts with the earnings environment. Are expectations really deteriorating as inflation, tax threats, the resilient virus and yes, China’s overextended lenders stack up against some of the greatest corporations in history?
Ahead Of The Curve
Here’s a bit of math for those of you who want to get past the noise and figure out exactly how strong the economy looks right now. It’s why I remain cautious in the short term but bullish when we start talking about next year and beyond.
Three months ago, we were dealing with inflation, tax threats and the virus, just like now. China wasn’t even an afterthought.
And when you polled all the analysts on Wall Street, we were collectively looking for 35.5% earnings growth for 2021 followed by another 11.4% for 2022. That’s a 51% expansion across that two-year period.
Admittedly, the “growth” rate this year is artificially high because the numbers were so soft in 2020. But even in the three-year period that started with the pandemic, the S&P 500 remains on a double-digit earnings trend . . . more than enough to keep a rally alive.
What’s interesting, however, is that while the headline growth number for 2022 has dropped to 9.7% over the last three months, it isn’t actually because of any worsening threats to the recovery.
The problem is that corporate performance has been so good this year that it’s left the analysts behind the curve. Some are struggling to raise their targets, but even so, it’s going to take time for Wall Street to catch up with the great things happening on Main Street.
Remember, the analysts collectively expected 35.5% earnings growth this year. With three months left on the calendar, it now looks like we’re on track to get a headline number more like 42% or 43% . . . a pleasant enough surprise in its own right.
But with so much unexpected profit already flowing through these companies, every percentage point of growth represents more real dollars and gets incrementally harder to achieve.
We simply have to do the math. Factor 9.7% anticipated growth for 2022 onto what looks like 43% growth this year and the S&P 500 will earn close to 57% more next year than it did in 2020.
And remember that the two-year growth target was only 51% three months ago. The earnings horizon isn’t closing in on investors at all. In the long view, the trend is getting steeper.
All the models on Wall Street now say that more money is flowing through Main Street and back into shareholder pockets than ever. Those models are up to date.
They include the likelihood that the Fed will be able to step away from extreme stimulus and swing back to raising interest rates again. And they include all the bickering over taxes, the inflation numbers, what we’re seeing in the job market.
Fear Factors And The Fundamentals
But are all the analysts wrong? If they are, experience teaches us that their main error is aiming too low to line up with commercial reality.
It’s easy to be negative. Wall Street wants to cater to clients who want to indulge their dread . . . but the big banks also want to keep people in the market where they actually generate trade flow and ultimately fund the bonus pool.
A lot of analysts aim low because there isn’t a lot of risk that a company will make too much money. If your clients are in a stock that surprises “to the upside,” everyone will cheer.
Meanwhile, I’m impressed with the quality of corporate leadership in the last few years. While not every CEO is brilliant, on the whole they’ve risen to the challenge of the pandemic and figured out ways to put the Fed’s endless money to work.
They’ve built new businesses. When it makes sense, they’re buying rivals to bolt onto those businesses, eliminating competition and generating additional efficiencies.
When the year started, the best guess was that revenue across the S&P 500 would climb a healthy 9% on the back of all these initiatives in 2021 and then flatten out to a more modest 6% next year.
Now we’re looking for 14% revenue growth by the time 2021 winds up, and while the year-over-year percentage rate for 2022 isn’t rising a whole lot, enough of that sales bump will recur that the numbers are going in the right direction.
More money coming in means more freedom to protect your margins when outside forces get in your way. And in the absence of outside threats, gains on the top lines simply move toward the bottom.
That’s a great fundamental situation. Classically, it’s how you get a boom and a sustainable bull market.
If other traders don’t believe in the numbers, let them sell out whenever they get nervous. We’re still here, accumulating every dip.
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Cannabis Corner: You’ve Got To Widen Your Screen
This was the week Aurora Growth Corp. (ACB), the third-largest cannabis grower around, laid off 8% of its work force and investors recoiled with horror.
Normally mass layoffs are a sign of discipline. But for ACB, the news is being greeted as an admission of failure.
And it’s worth a review of how exactly companies like this function in the broader market ecosystem. ACB isn’t profitable. It needs to grow its way to positive cash flow and sustainable operations.
Until it hits that scale, it needs to burn shareholder cash to survive. When it runs out of cash, it needs to ask shareholders for more.
Cutting production and scaling back other initiatives is unlikely to accelerate that trajectory. If anything, a smaller operation points to slower growth or even reduced sales on the horizon.
Investors needed to see proof that the discipline would leave a sustainable core for future growth ahead. We didn’t get that.
I think ACB could be in trouble if management can’t find a way to pivot. And, to a lesser extent, rival names at the top of the cannabis chain like Canopy Growth Corp. (CGC) need to watch developments here very carefully.
They can absorb a weakened competitor. Or simply go their own way and pick up supply contracts.