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The Macrodesiac Veteran has been scouring the Q1 earnings reports.

Here's what he found...

8 weeks ago we started Q1 2021 earnings season.

We can now look back over those earnings to see what we can learn and what the markets' reaction can tell us about how equity markets will behave as we move properly into the summer months.

First of all, let’s look at some numbers now that the vast majority of S&P 500 constituents have reported Q1 2021 earnings...

  • 86% of those stocks have reported a positive earnings surprise
  • 76% reported a beat in revenues
  • S&P 500 registered its highest number of positive earnings surprises since 2008
  • The level of those earnings beats at +22.50%, smashed the five year average of just +6.90%
  • Earnings growth for the top 500 US  stocks came in at +51.90% for the quarter: the biggest percentage rise since the first quarter of 2010.
  • 10 out of the 11 S&P sectors posted earnings growth in Q1 2021, with only industrials posting a decline.
  • The consumer discretionary sector posted earnings growth of +231% and the sector also had the biggest beats, with earnings exceeding analysts forecasts by a whopping +57.30%.

In terms of the widest breadth of earnings beats, we need to look elsewhere.

94% of stocks in the information technology sector and 88% of those in communications services beat their earnings forecasts.

In terms of the market reaction... stocks that beat earnings rose by an average of +1.20% over the two days on either side of their numbers.

Whilst stocks that reported an earnings miss were marked down by -0.90% over that four-day period.

The 5 year averages for these metrics are +0.80% and - 2.50%.

This shows us that the market reacted positively to good news and took any bad news very much in its stride.

Perhaps the only fly in the ointment for Q1 earnings was the relative lack of guidance offered by companies for Q2.

Of those that did offer guidance, 33 companies were negative on their earnings outlook whilst 54 had a positive outlook for the second quarter.

In terms of valuation, the 12 month forward price-earnings or PE ratio for the index is 21.2 times, which is well ahead of the 5 and 10-year averages of 18.0 and 16.0 times respectively.

Those premiums suggest that investors believe that US blue-chips will continue to beat Wall Street forecasts over the coming quarters.

However, not everybody is in agreement with that stance.

Morgan Stanley recently published a strategy note on US equities that suggested a -10 to -20% decline in the PE ratios for the S&P 500 were warranted, simply because the economy was in what it termed a mid-cycle transition.

They argue that rates of change in both growth and monetary policy have peaked, and higher taxes levied by central government and the tapering of asset purchases by the central bank would effectively take the wind out of the markets' sails.

That combination of rising input costs and slowing growth should push valuation multiples lower.

The investment bank also talked about a tug of war developing between earnings and valuations, which have up until now been pulling in the same direction.

Morgan Stanley first suggested that we would see this kind of mid-cycle correction back in November 2020 and despite the fact that it is yet to materialise, their US equity strategy team hasn’t changed its mind.

Morgan Stanley isn’t saying get out of equities completely, however.

Rather it’s suggesting repositioning so as to prepare for this midcycle bump in the road. Which they liken to the period after WWII from an economic and monetary policy standpoint.

With that in mind, they recommend financials that will benefit from rises in interest rates, materials that stand to benefit from rising commodity prices and demand created by spending on infrastructure.

They favour consumer staples over consumer discretionary stocks which suggest that US consumers may tighten their belts once normality is restored. And finally, they suggest reasonably priced growth and quality stocks which they say can be found within Healthcare and certain parts of the communications services sector, which they prefer to tech.

This defensive positioning is justified they say because risks in equity markets will shortly start to outweigh rewards.

For example, when PPI or factory-gate inflation is running higher than CPI, the consumer price index, then profit margins come under pressure as under these conditions, manufacturers and service providers cant easily pass on rising costs to the end consumer.

As this chart shows, PPI looks to be starting to outrun CPI in 2021.

The consumer of course accounts for as much as 70% of GDP in the modern US economy, so their behaviour and spending patterns carry a lot of weight.

However, one factor that perhaps Morgan Stanley hasn’t considered, is that the S&P 500 stocks which generate less than 50% of their sales in the US grew their Q1 revenues almost twice as fast as those companies that are focused solely on the domestic market.

The stocks that grew their revenues the quickest were those with more than 50% of sales coming from overseas and at least 25% of those total revenues from the Asia Pacific region.

Those stocks grew their revenues in Q1 by an average of 21.6%! More than twice the rate for the index as a whole which stands at 10.7%.

The inference here is that S&P 500 stocks that look outside the USA for their living could offer faster growth and an attractive hedge against any slowdown in the domestic economy.