VOO: Q3 Earnings Season Is Likely To Be Fantastic

Summary

• Q3 earnings season is likely to shift to a more fundamentally driven market narrative, relying less on yields.
• Macroeconomic data during Q3 has been strong, increasing the likelihood for earnings beating consensus analyst estimates.
• Market participants have to carefully watch and assess the potential economic fallout from Evergrande, as it could cause intermediate downside volatility.

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Thesis

Vanguard S&P 500 ETF (NYSEARCA:VOO) is likely to move higher as Q3 earnings season begins in a few weeks. Markets current overemphasis on yields is expected to abate as the yield narrative shifts away to a more fundamentally driven narrative on earnings.

The companies within the SP500 are likely to be more influenced on earnings and, to a lesser degree, on yields (as they have been up until this point) and their influence in DCF-models as earnings season begins.

Macroeconomic data has been robust during Q3, resulting in a majority of companies beating consensus estimates in earlier quarters. In addition, statistics show that actual results regularly beat consensus estimates as they are intentionally placed slightly lower to increase the likelihood of them being beat.

For these reasons, I consider VOO to be a BUY.

VOO

VOO has risen at the backdrop of strong monetary and fiscal stimulus since the start of the pandemic and has currently sold off a bit.

Koyfin

This slight decline has been attributed to many factors: ranging from autumn volatility, with September/October being historically associated with higher volatility, to rising yields (caused by higher inflation) and Evergrande contagion fears from China.

So, let us begin by analyzing the seasonality patterns of the SP500.

Seasonax

Analyzing seasonality from a sample period of 1950 to 2021 shows a seasonality effect of September and October being more volatile than other months of the year.

Monthly average returns show an underperformance of September, with a reversal of returns higher during October.

Seasonax

This particular reversal for positive monthly returns in October is most likely attributed to the earnings season beginning for Q3. Companies beating consensus estimates, resulting in a revaluation of higher share prices in DCF-models.

Consensus estimates by analysts are intricately linked to the forward guidance companies provide. Usually, analyst estimates do not deviate too far from forward guidance ranges given by management (since it is considered that management is the ultimate gauge of future estimates given their insider knowledge).

Forward guidance ranges are also knowingly placed slightly lower than expected quarterly/annual results by management. This increases the chance of actual released figures beating forward guidance ranges, reflecting positively on management.

As such, there is a bias for released quarterly/annual figures to beat analyst expectations consistently. I proceeded to analyze the majority of the constituent SP500 companies to see whether they beat consensus estimates each quarter, and an estimated 75%-80% regularly beat estimates every quarter.

Analyzing current Q3 earnings estimates, the fundamental backdrop has not changed according to FactSet data.

Analysts and companies have been much more optimistic than normal in their estimate revisions and earnings outlooks for the third quarter to date.

As a result, expected earnings for the S&P 500 for the third quarter are higher today compared to the start of the quarter. The index is now expected to report the third-highest (year-over-year) growth in earnings since Q3 2010 for Q3.

Analysts also project earnings growth of more than 20% for the fourth quarter of 2021. These above-average growth rates are due to a combination of higher earnings for 2021 and an easier comparison to weaker earnings in 2020 due to the negative impact of COVID-19 on numerous industries.

- FactSet

Q3 is projected to show near-record earnings, with figures only seen since last 2010. So, while markets are currently overly concerned with the yield picture, the focus will likely shift to positive fundamentals, as inferred by earnings beating expectations as the earnings season kicks off in the middle of October (at or around October 14th).

This will likely cause a shift in market sentiment, as markets will be more driven on fundamentals and less on inflation readings. There is a delicate balance concerning earnings & inflation, with markets at times of crisis and early recovery being overly focused on inflation as a proxy for monetary policy and its implications on valuing equities.

As the economy improves and as monetary policy becomes more hawkish, the primary driver for equities becomes earnings growth, and less so, an overemphasis on yields. There is reason to believe that the current narrative in markets, focusing on a more hawkish FED, is likely to subside as markets become fundamentally driven, incorporating and accepting higher interest rates along with an increased focus on earnings growth (not on yields as it is now).

Therefore, the current volatility we have been seeing is more of a re-adaption of markets to higher interest rates and eventually to a more fundamentals-driven valuation of equities.

Besides the historical figures I presented, there are additional reasons to believe that earnings will beat estimates. Firstly, we've had a record slew of macroeconomic indicators pointing to a strengthening in the labor market, high retail sales, and increased consumer spending.

This macroeconomic data can be used to infer how the Q3 earnings season will play out, if the data has been this strong, then it is likely that released Q3 figures for companies during earnings season will be strong as well.

Considering that the SP500 (and VOO mirroring it) serves as a reflection of the aggregate U.S. economy, there is a high degree of likelihood that VOO will continue higher in the middle of October as earnings season begins.

Let us now discuss risks.

Risks

Evergrande and the potential contagion effects that could ensue if the company defaults pose a risk to global markets. The company is currently selling off assets, and it is unclear if it will be able to pay off its $300b debt.

In the case of bankruptcy, there could be intermediate downside volatility, overshadowing the positive fundamentals the markets are likely to focus on during earnings season. This could lead to markets, and VOO, dropping even as earnings come in better than predicted by analysts.

It is important to consider the time it could take for Evergrande to completely resolve its debt situation, as it could take months, meaning that Evergrande could be a constant overhang on markets as the situation evolves.

In the event there is bankruptcy, and significant contagion effects arise, there is a likelihood of a prolonged slump in equity markets as endogenous economic crises take, on average, a longer time to resolve than exogenous caused crises (COVID-19, e.g.). This is especially true for China, as it is one of the largest economies of the world and a powerhouse of global GDP growth.

While this might initially seem like an overly gloomy scenario, a potential Evergrande bankruptcy could lead to a period of prolonged loose monetary policy and fiscal stimulus within China and other geographies to battle the economic fallout of an Evergrande crisis.

Paradoxically, this could lead to equity markets continuing their ascent higher as bad news becomes good news. As such, irrespective of the outcome, there is a high degree of likelihood that equity markets, including VOO, continue their ascent higher.

It should also be noted that a large majority of the companies in the SP500 show stable and mature cash-flow profiles, focusing on technology stocks making up a substantial part of the index. As such, ownership of these companies over a longer time horizon is likely to result in capital appreciation regardless of imminent markets' concerns.

Summary

The market's current focus on yields will likely change as earnings season begins, with stocks probably beating consensus estimates resulting in a shift from a yield-oriented narrative to a fundamentally-oriented narrative on earnings.

This comes at a juncture of a more hawkish FED and the economy shifting into a middle-phase of the business cycle. Share prices will begin to carry their valuations purely on fundamental factors (earnings growth, e.g.) and become less reliant on yields and their influence on valuation in DCF-models.

Market participants will have to carefully assess the Evergrande situation, as it could be influencing markets for many months before clarity comes as to how much exposure institutions have against their debt. As such, investors have to be prepared for volatility. In the event of total default, additional stimulus will likely become unleashed, increasing the bullish narrative once again as bad news becomes good news.

For these reasons, I would consider VOO a BUY.

Analyst’s Disclosure: I/we have no stock, option or similar derivative position in any of the companies mentioned, and no plans to initiate any such positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Comments

[moseharper]

Volatility has been the pattern for some time, no thanks to the possibility of an increase in income taxes, capital gains treatment, elimination of the step-up in inherited assets, etc. as well as inflation fears, Covid, and, as mentioned, the Evergrande situation. Still, even with this scenario and a pattern of large daily swings in the markets, optimism is still present. VOO is a good choice to ride this out and hold on to in the long run.