The U.S. third-quarter corporate earnings reporting season will kick off next week and the numbers will reflect a second quarter dominated by the coronavirus pandemic that has created an uneven playing field in which some companies thrive, while others shrink and fade.
While stock indexes have set records and big technology and online retailers have outperformed, many other industries and individual companies are grappling with deteriorating sales and earnings as economic growth has slumped across the globe.
“A lot of company risk is not being captured by equity indices,” said James Gellert, chief executive of Rapid Ratings, a data and analytics company that assesses the financial health of private and public companies. “The equity market is showing a lot of optimism, but below the surface, there’s an ocean of companies that are dealing with a crisis.”
Companies doing business with bigger enterprises in hard-hit sectors that sell to or buy from them are aware of the financial health of those customers or vendors, he said. The market may suggest a company is doing well, but the difference between financial health and market health “can be very different.”
Sebastian Leburn, senior portfolio manager at Boston Private, agreed. “You’ve got the economy and the stock market, and you’ve got the S&P 500,” Leburn said.
Leburn noted that the S&P 500 index SPX, +0.75%
is market-capitalization weighted, so its performance is skewed by just a handful of mega-cap tech stocks. Those companies, led by Apple Inc. AAPL, +1.05%,
Amazon.com Inc. AMZN, +2.70%,
Microsoft Corp. MSFT, +2.00%
and Google-parent Alphabet Inc. GOOGL, +1.21%,
represent roughly one-fifth of the index, and have benefited from business lockdowns resulting from the pandemic. However, the average stock is not doing quite as well.
While the S&P 500 is up 7.6% year to date, the S&P 500 Equal Weight Index SP500EW, +0.27%
has declined 1.2%. And the S&P 500’s post-pandemic record high was 5.7% above its pre-pandemic high in February, but the S&P 500 Equal Weight post-pandemic high in September was 3.8% below its February record.
S&P 500 companies’ overall earnings performance is expected to be less bad than the second quarter, when earnings fell the most since the 2008 financial crisis, according to FactSet data. The aggregate blended year-over-year growth estimate for S&P 500 earnings per share, which includes some earnings already reported and the average analyst estimates of coming results, is negative 20.5% as of Friday morning, following a 31.4% plunge in the second quarter.
Investors may be more focused on the rate of change in the decline, rather than how far earnings are falling. They’re also likely looking much further into the future for signs of growth in a post-pandemic world.
“The story, if you want to believe it, is that the June quarter was the low, and earnings estimates are going to get better from here,” said Leburn. “They’re negative, but they’re less negative.”
Gellert agreed. “It’s not as clear as better or worse. The second quarter was terrible, and this will be better than terrible, but still not necessarily good.”
Andrew Slimmon, a managing director and senior portfolio manager on all-long equity strategies at Morgan Stanley Investment Management, is more concerned with how earnings look relative to what Wall Street is expecting.
“I don’t care that we’re looking at down earnings, I care whether companies are going to do better than expected,” Slimmon said.
And analysts are expecting results to be better than initial estimates, for the first time in more than two years.
Analysts are raising estimates for the first time in 9 quarters
The earnings decline may be slowing, but the third quarter will be the third-straight quarter of declines, following 31.4% drop in the second quarter and 14.1% fall in the first quarter. And while Wall Street is estimating a significant improvement in the fourth quarter, the estimate currently calls for another double-digit decline, of 12.7%.
The third-quarter outlook does stands out a bit, however, as the current estimate of a 20.5% decline compares with the estimate of a 24.4% drop as of June 30. That marks the first time estimates have improved during a quarter since the second quarter of 2018. Over the past five years, estimates declined by an average of 5% during a quarter.
What might that mean for the S&P 500 index? From mid-July 2018, when the second-quarter 2018 earnings season kicked off, the S&P 500 rose 4% through the end of the third quarter, reaching a record high in the process. Then the bottom fell out, as the index tumbled 14% over the final three months of that year, and hit a 20-month low in the process, amid concerns over the economic impact of a trade war with China and rising interest rates.
Numbers are negative for all sectors
So far, all 11 of the key S&P 500 sectors are expected to see earnings fall from last year. Energy is leading the way with an estimated 122.7% drop in earnings, followed by industrials at negative 60.4% growth and consumer discretionary at negative 36.9%.
The sectors currently expected to perform the best are health care at negative 0.6% and information technology at negative 2.7%.
Although the overall decline in the second quarter was bigger, three of 11 sectors saw earnings rise, including health care and technology.
Seven sectors have seen estimates improve since June 30, with consumer discretionary showing the biggest improvement — negative 36.9% from negative 52.0% — followed by financials, to negative 18.8% from negative 30.8%.
Meanwhile, the outlook for sales is much better, with analyst expectations pointing to 3.5% decline overall, following a 9.2% drop in the second quarter. Five of the 11 sectors are expected to post positive sales growth, led by health are at 7.3% and consumer staples at 2.3%. Energy is expected to suffer the biggest sales decline at 31.5%.
For the fourth quarter, the sales decline is expected to improve to 1.4%.
Gellert from Rapid Ratings said companies who came into the crisis with stronger financial health ratings, a metric that looks at one-year short-term default risk and viability, are naturally faring better than those who did not.
In the airline sector, for example, he said Southwest Airlines Co. LUV, +1.59%
and American Airlines Group Inc. AAL, +0.57%
offer a case in point. Southwest started 2020 with a financial health rating of 91 out of 100, and it has now deteriorated to 72, which is still strong. American, in contrast, started the year with a financial health rating of just 56 out of 100, which has now deteriorated to 24.
Capital markets are full steam ahead
After raising record amounts of capital in the debt, equity and convertible bond markets in the second quarter, companies continued to borrow or issue stock in the third quarter as they struggled to bolster liquidity.
U.S. companies have issued a record $1.48 trillion of corporate bonds in the year to date in 1,317 deals, according to data provided by Dealogic. That shattered the previous record of $928.8 billion issued in the same period in 2017 in 1,002 deals.
Companies have issued $385 billion of equity in the year so far in 1,071 deals, crushing the previous record of $276.6 billion issued in 2000 in 870 deals. They have issued 91.5 billion of corporate bonds in 156 deals, beating the previous record of $71.1 billion issued in 2007, in 164 deals.
The initial public offering market alone had its busiest quarter since 2000, the height of the dot.com boom, with 81 deals raising $28.5 billion. The high volume and effect of several large deals generated the most proceeds in six years, according to Bill Smith, founder and chief executive of Renaissance Capital, a provider of IPO exchange-traded funds and institutional research.
Anthony Denier, chief executive of Webull, a commission-free trading platform, said low interest rates and the Federal Reserve backstop are driving the trend.
“The whole point of the Fed lowering rates is to get companies to borrow more. And while companies won’t pay 0% on their loans, they will pay very little interest, so now is a great time to borrow. And with the Fed backstopping the bond market, there’s very little downside.”
However, companies still need the funds to service their higher debt loads, and will need to deliver adequate earnings and cash flow to manage it, according to Moody’s Investors Service.
“We expect that many investment-grade companies will continue to show resiliency to the economic stress caused by the coronavirus,” Moody’s analysts wrote in a recent note. “However, companies in hard hit sectors – including those rated low investment grade – have high hurdles.”
A sustained need for social distancing, for example, would totally upend the travel and leisure sectors, accelerate e-commerce trends, disrupt commercial real estate and extend oil price volatility.
Already, cinemas and entertainment events are reeling from social-distancing mandates, said Denier from Webull.
“The delay in releasing the new James Bond and Batman films is considered a disaster for the movie theater industry,” he said. “And with a resurgence in the coronavirus, entertainment venues won’t be opening anytime soon.”
The credit markets are reflecting more concern about the outlook than the equity markets, which is hardly surprising given there is so much capital to put to work.
“Businesses need to see demand for their products and services, but after falling off a cliff, demand is still very low,’ he said. “The current level of real yields is a signal that bond investors see a lot of weakness and uncertainty in the broader economy.”
The first earnings reports next week, from the nation’s big banks, are expected to reflect that. Banks are expected to have cleaned up on fees from investment banking activity, given the record pace of capital raising and mergers & acquisitions.
But their loan books are likely to reflect the stress especially in the small and medium-size business sector, and provisions for loan-loss reserves are expected to remain high, albeit below the lofty levels seen in the second quarter.
Also on the docket next week is Johnson & Johnson JNJ, +1.35%,
the pharmaceutical and consumer goods giant that is one of the companies developing a COVID-19 vaccine candidate. Investors will hope to hear data from the company’s Phase 1/2a trial, which began in the second half of July.
J&J said Sept. 23 that the vaccine candidate demonstrated a “safety profile and immunogenicity after a single vaccination were supportive of further development” and preprint results would be published imminently.
The company started to dose participants in its Phase 3 trial in September and is aiming to enroll up to 60,000 people.
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How much should you allocate of your retirement portfolio to emerging market equities?
It’s a timely question, since many widely-followed Wall Street firms are telling their clients that emerging market stocks are the only equity category whose expected return over the next decade is above inflation. Perhaps the most prominent of such firms is GMO, the Boston-based investment firm co-founded by Jeremy Grantham. It is projecting that the emerging market equity category will beat inflation over the next seven years by 5.0% annualized. In contrast, the firm is forecasting a 6.2% annualized loss to inflation over the same period for the S&P 500 SPX, +1.95%.
As is also widely known, however, GMO has been making similar forecasts for many years now, and at least so far has been very wrong. Over the trailing 10 years, according to FactSet, the iShares MSCI Emerging Markets ETF EEM, +1.09%
has produced a 3.4% annualized return, almost 10 annualized percentage points below the 13.3% annualized return of the SPDR S&P 500 SPY, +1.84%.
Fortunately for our purposes, Credit Suisse has just released the latest edition of its Global Investment Returns Yearbook, authored by finance professors Elroy Dimson, Paul Marsh, and Mike Staunton. This yearbook arguably is the most comprehensive database of global returns, as it reports performance since 1900 for “equities, bonds, cash, currencies and factors in 23 countries.” For the first time, furthermore, this year’s yearbook was “broadened to include 90 developed markets and emerging markets.”
This long-term perspective is especially crucial when assessing emerging markets. That’s because we can all too easily forget that many emerging stock markets disappeared altogether at various points since 1900 due to “major events such as revolutions, wars and crises.” Their losses need to be taken into account when judging emerging markets’ prospects, and this Yearbook does.
This long-term perspective is crucial for another reason as well: Some emerging markets over the last 121 years have performed so spectacularly that they graduated to the “developed” category. Index providers employ a complicated methodology for determining when that graduation takes place and, as you can imagine, a lot is riding on that determination. But the inevitable result is that some of these emerging markets’ spectacular performance gets credited to developed market benchmarks rather than to emerging market indices. This yearbook’s authors employ an elaborate methodology to place each market each year in the appropriate categories.
You may say you don’t care how a country’s stock market is classified, just so long as it performs well. But you should care. If you invest in emerging market equity index funds, you at least implicitly are relying on the decisions that index providers make about what counts as an emerging market. There’s no way around it.
Without further ado, let me turn to what the Credit Suisse Yearbook reports. Over the last 121 years, emerging market equities have produced a 6.8% annualized return to a US-dollar investor, 1.6 percentage points below that of developed markets’ 8.4% annualized. I note in passing that developed market bonds beat emerging market bonds over this period by a similar magnitude: 4.9% annualized versus 2.7%. These returns are plotted in the accompanying chart.
These long-term returns suggest that the last decade’s results are not as unusual as they may otherwise seem.
Do these results mean that there’s no need to allocate any of your retirement portfolios to emerging market equities? Not necessarily. Part of the rationale for investing in them derives from their potential diversification benefits: If they zig while developed market equities zag, and vice versa, then a portfolio that invests in both would incur significantly lower volatility, or risk, than one that invests in developed market equities alone. This in turn could translate to superior risk-adjusted performance even if emerging market equities underperform.
The yearbook’s authors find that emerging market equities do provide some diversification benefit. However, that benefit has been declining over the last several decades, as correlations between their returns and those of developed markets have been rising.
The bottom line? I came away from this latest edition of the Credit Suisse Yearbook with diminished long-term expectations for emerging market equities.
That doesn’t mean we should automatically avoid them. But we should base any decision to invest in them on other factors besides their long-term returns.
GMO and the other firms advocating for emerging market equities do just that, by the way, basing their bullishness on valuation considerations. They believe that emerging market stocks are very cheap, according to any of number of valuation metrics, both in their own right and relative to developed market (and especially U.S.) stocks.
GMO and similar firms may very well be right, of course. But the 121-year record suggests that they will have to be very right indeed to overcome emerging market equities’ long-term tendency to lag developed market equities.
I was married just over 2 years ago and I have been in the same relationship for more than 10 years. We have both been single parents from prior relationships. Considering our age gap, he is much more successful in life as a sole proprietor. He’s 56, and I’m 40. He talked about a pre-nuptial agreement during our relationship, but he did not spring it on my until 3 days prior to our wedding day.
We discussed nothing as to what would go into the agreement. I was severely depressed, cried uncontrollably for days. Even reliving this is causing heartache. I consulted with my attorney but decided to sign it rather than not go through with the wedding. For two years, I asked for a copy and he couldn’t find it: When I finally had enough, I found it in his office, and made myself a copy.
‘I’m angry at myself now because there are provisions I would have included had I had more time to think about it.’ ”
I still don’t fully understand what happened, and I’m angry at myself now because there are provisions I would have included had I had more time to think about it. My parents will be willing me a home, and a nice considerable amount of cash. I’m not in his will, there is no life-insurance policy, and I’m not listed on the deed of the second vacation home “we” bought before we married, but he wants to say how everything is ours.
Technically, it isn’t. Now that I am about to start my own venture, which may be lucrative, potentially six figures a year, I want to amend the prenuptial agreement. In a way, I want to hurt him the same way he hurt me. It’s caused a lot of resentment on my end as I feel he never trusted me, although I have never asked him for anything. If he dies tomorrow, what is going to happen to me?
Should I amend the prenuptial agreement? Is it possible that the current prenuptial agreement is null and void?
Postnuptial State of Mind in Pennsylvania
You can email The Moneyist with any financial and ethical questions related to coronavirus at email@example.com
You should know what’s in your own prenuptial agreement, given that’s it’s a legal document you both signed. I don’t understand why you did not have a copy when you originally signed the document, and why you didn’t actively insist on a discussion. With the help of your lawyer, that was your job to make sure that happened. You had the choice to call off the wedding and/or sit down and read every page. I’m not saying this to be provocative, but to remind you that taking responsibility for this sequence of events is more constructive than taking umbrage at your husband.
But let’s be very clear: Three days notice of a prenuptial agreement before your wedding without any willingness to compromise on the details or discuss them is sorely lacking in consideration, and is a chaotic and unsettling start to a marriage. I understand why it left you reeling, and why you felt both confused and angry. Prenups are enforceable in Pennsylvania, which is a marital property state, meaning that — in the absence of a prenup — assets are distributed in a fair and equitable manner. Inheritance is not considered marital property, so you should have no worries on that front.
Your prenuptial agreement should reflect that you both maintain your separate finances/assets in the event you divorce. In other words, what’s his is his and what’s yours is yours. He can’t have it both ways. According to Rowe Law Offices in Pennsylvania, “Historically, courts sometimes set aside premarital agreements when they were unreasonable; left one spouse destitute; were made without full disclosure of a spouse’s property and debt; were signed under duress or without mental capacity; were the product of fraud or misrepresentation; and so on.”
Should you amend the prenup? You can certainly create an amendment, as long as both of you are in agreement, or sign a new postnuptial contract that supersedes the original contract. But that is a question only you can answer based on what the prenup actually says, and whether you lawyer believes it is written in a way that gives you both the same financial independence post-divorce. The whole business seems messy and unpleasant. It was not a good way to embark on a marriage and, as a tangent to your question, it’s not a good way to continue one.
Certainly something needs to change. From the little you have said, it appears to be a marriage that lacks transparency and mutual respect. You need a financial therapist, a mediator or your own counselor to examine the causes and cures of this toxic atmosphere. Starting a business should be a time of optimism and joy, not steeped in an “I’ll show you” entrepreneurial revenge fantasy. Getting married is the biggest financial decision you will make in your life, if only because the toll divorce takes on an individual, and because you may end up taking turns supporting each other.
If this marriage ends, you should both leave with what you brought into it. Given that, the real issue here is not what happens in the event of a divorce, but everything else that comes before it.
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