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FBB Insights

2nd Quarter Earnings Season

2020 has been a year of surprises and dramatic swings in health concerns, economic trends, and stock prices. We continue to expect the unexpected, especially as Covid cases remain elevated, heavy job losses continue, and as we approach the Presidential election. With all these uncertainties surrounding investors, many are struggling to figure out what is next for markets.

As fundamental investors, we try to boil down all the medical, economic, and political themes into a bottom-line estimate of how companies will perform amid all the uncertainty, and for us the bottom line is corporate earnings. Historically, stocks tend to chase earnings.  With that in mind, we are taking another look at what recent profit trends can tell us about the next moves for equity markets.

This Spring, governments, businesses, and individuals voluntarily reduced economic activity for a chance of improving health security as lockdowns started in March, peaked in April, and started to unwind in May and June. For companies, the second quarter, which includes April, May, and June, started off terribly as economic activity slowed to a crawl in April. However, corporate profits started to recover by the end of the quarter as the economic freeze began to thaw out.

So, what happened with overall profits during this period of economic turbulence? Many companies shelved their profit forecasts as the Covid lockdowns began, leaving Wall Street to make an educated guess as to how fast profits would evaporate in the second quarter. Leading into the second quarter reporting season, many investors expected profits to plunge as much as 45% from the year-ago period, amid the cratering economy. However, as companies unveiled their results, the overall pain was a bit less than the consensus expectation as profits only fell about a third, year over year.

Winners and losers

The one-third drop in corporate profits last quarter is like saying your team had a losing season with some terrible losses and a few wins. Covid hit hard in parts of the economy where social distancing was impossible or where lower economic activity created a vicious cycle, while a few industries emerged with steady or improving growth.

A near-total wipeout for travel and leisure demand drove major declines in consumer discretionary profits in the quarter as hotels, airlines, and sit-down restaurants became ghost towns. The overall economic slowdown lead to lower industrial production for heavy equipment, rising bad debts for banks, and lower oil prices, which hit energy companies.

Amid all the gloom and doom, a few bright spots emerged as consumers stayed home, took care of their health, and shopped online as they worked from home. Steady electric power demand boosted utility

profits in the quarter, while mail-order prescription drugs and Covid testing drove growth for healthcare companies.

Consumers also shifted browsing and buying habits quickly as online ads and ecommerce spiked in the second quarter. Remote working and rising data usage boosted demand for cloud computing as well. Perhaps the most dramatic example of the haves and have nots in the quarter fell within the consumer discretionary sector, which includes ecommerce as well as traditional retailers. Amazon’s second quarter earnings doubled over the prior year, while profits outside of ecommerce fell 90%.

What next for earnings and stocks?

As companies lick their wounds coming out of the second quarter, we look ahead to economic trends that may drive corporate earnings in the back half of the year. Our sense is the wide gulf between winners and losers in the second quarter will start to close as time marches on. In particular, a reopening economy will likely increase demand for industrial production, oil, and even travel and leisure pursuits. Still, the black cloud of Covid will likely extend a corporate profits recession through year end as the hurricane that hit profits in the second quarter weakens into a nasty storm as we approach 2021.

Since stocks have recovered much faster than earnings, many investors are struggling with how to position their portfolios. Stock prices are likely banking on glide path toward a vaccine and an economic recovery, while in the short-term, corporate profits may struggle as the economy navigates through some turbulent air. Over the next few months, companies will be fighting to escape the bad old days of declining earnings as they do the blocking and tackling involved in growing sales and profits.

We find ourselves in a tricky situation where stocks are up, but earnings are down, prompting us to take a defensive posture for client portfolios in case Covid trends worsen, or the economic recession lingers. We generally favor defensive sectors plus technology as these parts of the economy may perform well in a recovery or another downturn. Additionally, we prefer a bit more cash to allow opportunistic purchases in case markets take another dip.

Second quarter earnings likely marked the bottom of the Covid cycle for the economy and future periods will probably start to claw back some of the losses related to the pandemic. With this in mind, we will continue to monitor earnings trends as a barometer of the next move for markets. While markets may continue to surprise investors in the coming months, a grounded focus on bottom line results should help provide a guide toward future growth.

 

Michael D. Bailey, CFA
Director of Research

 

All opinions expressed in this newsletter are not intended to be a guarantee or forecast of future events, do not constitute a solicitation to buy or sell securities nor are they a complete description of our investment policy, the markets, an investing strategy or any securities referred to in the newsletter. Opinions expressed herein are not intended to be used as investment advice and are subject to change without notice based on market and other conditions. Different types of investments involve varying degrees of risk, and there is no assurance that any specific investment will either be suitable or profitable for a client’s or prospective client’s investment portfolio, and no one should assume that any information presented here serves as the receipt of, or a substitute for, personalized individual advice from FBB Capital Partners, its research team or its portfolio managers. The value of investments and the income from them may fluctuate and can fall as well as rise.

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