A Strong Q2 for US Corporate Earnings and Sales

As this volatile, up-and-down week continues, there is one key item we haven’t touched on: Corporate earnings. We would be remiss not to, since stocks are a share in companies’ future profits—and since much of this week’s market coverage extended blame to some bad earnings reports. Granted, there were some high-profile misses. But overall, Q2 earnings have been pretty darned good thus far. Backward-looking and not indicative of where things go from here, but good nonetheless.

Currently, 449 of the S&P 500’s 503 constituents have reported Q2 results. Per FactSet’s Earnings Scorecard, earnings are up 10.6% y/y, beating consensus expectations for 8.9%.^[i] Nine of 11 sectors grew, with only Industrials (-0.9% y/y) and Materials (-7.1%) in the red.^[ii] Sales were strong, too. Total revenues grew 5.2% y/y, beating expectations for 4.7%, with all sectors save Materials (-1.4%) up.^[iii] Profits are strong and broad-based and fueled by demand—not rampant cost cuts. This all reflects activity from April through June, which stocks have already lived through and priced in advance. But it shows that through the first half of the year at least, the bull market’s engine was chugging along. 

Of course, what matters most isn’t absolute results, but how results square with expectations. After all, stocks move most on the gap between what people think will happen and what actually happens. Earnings that grow but miss expectations by a country mile tee up disappointment.

While aggregate earnings and sales beat expectations, there were exceptions. A big one: Communication Services, one of this bull market’s darlings. This sector is kinda new, a mash of the old Telecom sector (now a resident industry) and some transfers from other sectors (e.g., Tech and Consumer Discretionary) whose business models didn’t quite fit their peers. Because some high-profile former Tech companies live in this sector, many consider it Tech-lite, putting its earnings under a microscope. Right now, that microscope shows the sector’s earnings up 4.0% y/y, badly missing expectations for 16.6%.^[iv]

Yet the weakness didn’t erupt from the Interactive Media and Services industry, which is where the former Techies are. This industry smashed expectations, with earnings up 39.6% y/y—the consensus penciled in just 26.5%.^[v] No, the trouble centered in the Entertainment industry, where analysts projected 58.3% y/y earnings growth, only for results at two videogame makers to miss. Additionally, a movie studio/cable/streaming video firm took a massive writedown on its cable channels to tank industry earnings to the tune of -284.6%. The latter reflects a well-known societal shift, not a sudden drop in demand.

Elsewhere, things were fine. Tech earnings grew 18.4% y/y, beating expectations for 14.6%.^[vi] Consumer Discretionary’s 11.9% y/y growth beat expectations for 4.8%.^[vii] Both sectors’ revenues beat estimates, too. To the extent markets seemed to react negatively to some of these growthy reports, it was more about nitpicking company guidance, trends in a single business unit or just plain coincidence with the broader volatility. These things can be difficult to pin down. But knee-jerk reactions to this stuff are normal and usually even out before long. Furthermore, companies have long used cool guidance to keep expectations down, making earnings beats easier to attain.

It is tempting to flag the commodity-heavy sectors (Energy and Materials) as potential trouble spots, given Materials earnings notched the largest drop and Energy, though up, missed estimates (growing 1.9% y/y, versus expectations for 8.7%).^[viii] To the extent this indicated weak demand for oil, gas and natural resources, it could be a sign of the global economy downshifting. However, in Energy, pressures were more on the cost side of the ledger, as revenues’ 8.1% y/y growth beat expectations for 3.7%.^[ix] Demand in this oil price-sensitive sector seems fine to us.

Materials’ revenues fell, but the pressure on both earnings and sales eased relative to a very bad Q1. We don’t call a slower decline an improvement, but the consensus expects growth to return in Q3. Industrials, also cyclical, generated similarly brighter expectations for Q3. We will concede that this isn’t an airtight indicator, as analysts could just be loath to acknowledge they were wrong about a trend rather than too early. But given how well-known manufacturing’s soft patch is, we sort of doubt this is a case of head-in-the-sand optimism.

If you have read this far and are muttering the name Pollyanna under your breath, we get where you are coming from. But there is a very simple reason we are digging into the stories accompanying this pullback to see if their credibility holds up: Reacting to volatility is perilous. If you decide to get out of stocks after a drop, you had better have a darned good reason to believe there is a lot more downside ahead. Otherwise, you risk getting whipsawed—selling after a decline, missing the rebound that follows and then confronting the difficult question of when you eat crow and buy back in. That last part is a very tough emotional and psychological challenge investors dismiss at their own peril.

So when big volatility hits, we think it is important to assess the full landscape, looking objectively at the evidence and thinking from first principles. We will keep doing so, and if we start seeing warning signs, our pride won’t block us from saying so. But for now, that isn’t the case. This still looks like the market overreacting to scary stories that will soon blow over.