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Last time, we looked at some of the factors at play in the conflicting signals we observe between the bullish and bearish forces in today’s markets. In this article, we’ll delve into the current earnings season to assess these conflicting forces and try to gauge what they mean for investors.
Paying up for poorer earnings doesn’t seem like the optimal investment strategy. Regardless, that’s what investors are doing at the moment. Valuations for the S&P 500 are quite elevated. Looking back in history, valuations have been higher a few select times. But we’re talking about the highest valuations in the last 20 years, except for the post-Covid period, where earnings were still depressed, rates were at rock bottom, and QE was flowing like Niagara Falls.
At present, just under half of members of the S&P 500 have reported quarterly results. Including all of the Mag 7, which, by and large, posted broadly strong, but not blow-out results across the board like some of the stock prices would have suggested.
At this stage in the earnings season, the overall performance of the market continues to be sub-par. 230 companies have reported 4Q results. Reported sales growth has been +3.4% and earnings +4.0%. Despite the slow growth, we continue to see positive surprises generally across the board. Price action is arguably more important than actual stated results, and despite a +7.1% aggregate earnings surprise, the average one-day price movement is just 0.1%. Suffice it to say that, on average, the market has not been rewarding the beats, but it has been punishing those who have missed.
Eight of the 11 sectors are reporting earnings growth, led by Communication Services, Utilities, Consumer Discretionary, and Technology. Energy, Materials, and Health Care are thus far reporting fairly significant earnings declines. Looking ahead, analysts are calling for earnings growth of 9.6% in 2024 and a whopping 13.0% in 2025. Headline EPS estimates for 2024 are, however, trending lower, down nearly a percent over the past few months. The abrupt shift in the 3M revision a few months ago conflicts with a massive surge in stock prices to close out 2023.
Markets didn’t take well to some of the big misses, including Microsoft and Google. Add in Powell’s unclear messaging during the FOMC conference, and markets saw a sharp reversal to close out January. Though analysts remain rather optimistic, they continue to dial it back. It appears falling inflation might be good for rates but not for earnings.
Recession fear has receded, and mentions of the dreaded “R” word have been falling for the past few quarters. Another clear trend is the lack of mentions of inflation and interest rates. We’re seeing some lingering concern regarding commercial real estate, notably from some U.S. regional banks. Pandemic darlings continue to struggle (anyone interested in buying another spin bike for their basement?). One company in particular could really use the sale. Markets were looking for confirmation of sunnier times this earnings season, but, by and large, based on the guidance changes, companies on aggregate have missed the mark.
The number of S&P 500 companies issuing negative earnings per share guidance for the first quarter outnumbered those issuing positive guidance. In the chart below, we plot the trend of higher and lower guidance revisions over the past few years. With just 18% of companies guiding higher versus 38% guiding lower, the ratio is now over 2-1, the highest we’ve seen over this period.
“Is Value Investing Dead?”... “The Demise of Value Investing”...“Value investing is struggling to remain relevant.” These are all headlines from the end of the decade after an incredibly strong period for growth stocks. Many would say that investors were happily dancing on the graves of value stocks as their portfolios climbed beyond their wildest beliefs. The media narrative has not changed much since the beginning of the new decade. Technology commentary continues to dominate the media headlines, and who can blame them? The growth potential for A.I. is much more exciting to learn and read about than the fundamentals of Coca-Cola.
Investing in fundamentals has never been loud or exciting, but it has provided consistent returns over long periods of time. Over the last three years, we were aware that value was having a strong run, likely somewhere near growth equities, but growth was likely winning due to AI, tech dominance, chip shortage, etc.
While the narrative in the media may not have changed, the shift from growth to value has already begun. When discovering it was strongly opposite to what we believed, we decided to survey 31 financial professionals who deal with high-net-worth families throughout Canada. Our thesis was correct; even though value has dominated the three-year period, a majority (71%) of financial professionals believe growth has been the stronger factor.
This is to no fault of the investor; there are many behavioural biases at play here, with the most dominant one being the “availability bias,” also known as “recency bias.” Our recent encounters with investing, especially over the past decade, and exposure to media content have heavily leaned towards discussions of growth. This has left the door wide open for value investors to quietly outperform. Given the inherent biases in investing, it is crucial to remain steadfast in your convictions and resist anchoring to media-driven narratives.
While the three-year view looks very strong for value (S&P 500 Value +44% vs S&P 500 Growth +21%), in two out of the three calendar years below, growth has outperformed value. Not by as much as you might think, but growth did outperform. 2022, the year rate hikes began, was a big reason for the outperformance over the period, with value outperforming growth by 24% (S&P 500 Value -5% vs S&P 500 Growth -29%). But that is what value is meant to do; when you get this larger pullback in the market, your blue-chip value stocks should hold up better.
Lucky for us, calendar years are arbitrary; as long-term investors, we are focused on exactly that – the long-term – and this type of portfolio construction is proving to be beneficial given the current market environment.
For much of the current decade, we have been consistently overweight value, most notably in the realm of U.S. equities. While the positioning has been successful thus far, the primary focus should be on what will happen in the future. There are a few key reasons that lead us to believe there will be continued outperformance of value.
The sustainability factor comes down to good old-fashioned diversification. Unsurprisingly, approximately 90% of the return for the growth index throughout these three years can be attributed to one sector: Technology.
Flipping over the value index, to achieve the same 90% coverage for return, you must include the top seven performing sectors of the index. While there are certainly differing opinions in the investing world, there is likely a preference for investment growth to be diversified amongst seven sectors rather than depending solely on a single one. This type of investment growth does not feel particularly sustainable over the long run.
Simply put, the U.S. growth index is expensive, and as we wrote recently (“Do Valuations Matter?”), the more expensive the index, the lower the forward returns have been historically. The growth premium has made its way back to nosebleed levels last seen in 2021.
While the markets did move much higher throughout Q4 of 2023, mainly due to multiple expansions, price does not entirely explain the quick shift in valuations that we saw at the end of December. The more impactful explanation for the return of the growth premium comes down to forward earnings estimates.
The earnings estimates for growth companies in the S&P 500 pulled back while the forward earnings estimates for value in the S&P 500 strengthened. Therefore, a significant amount of the P/E growth premium climbing has to do with the “E” moving in opposite directions for both styles. We expect that trend to continue as some of the earnings estimates for the growth companies were/are certainly extended.
While the current inflation level has come back down, our view is that it will continue to flare up through the cycle and, on average, remain at higher levels than the last cycle. Looking back over the last 48 years, this has proved positive for the value factor.
There was roughly the same number of periods when U.S. CPI was greater than 3% as there was when CPI was less than 3%. Separating those two periods, value stocks outperformed on an average monthly basis by +25 bps in periods where U.S. CPI was greater than 3%. The opposite can be said for periods where U.S. CPI was less than 3%; growth outperformed value by +23 bps.
During a period of rate cuts, we can expect growth to outperform value. However, if inflation proves more volatile over the long term, so will the rate environment, meaning we may not be going back to the depths of interest rates. A more consistently elevated rate environment should prove to be a boon for value.
Recognizing new cycles early on is crucial for maximizing future returns. After a decade of underperformance in value, the time for value investors may have arrived. While the U.S. equity market has distinct value and growth factors, other markets, such as the TSX and international markets, appear value-heavy based on current valuations. This forms the basis for our underweight position in the growth-heavy U.S. market, market-weight in Canada, and overweight in international equities.
While we acknowledge the possibility of mixed performance between value and growth for the remainder of 2024, our preference leans towards value, aligning with our forward-looking strategy. Our stance doesn’t imply a complete dismissal of the growth factor. We remain cautious about potential challenges, such as a recession, where growth may exhibit some resilience. However, our focus is on anticipating future trends, and currently, that points towards a value-oriented approach. Spread the word – value is on the rise, and we aim to keep this momentum for the dedicated value investor.
The market's ongoing battle between optimism and pessimism, represented by bulls and bears, remains a driving force in the financial world. Investors navigate conflicting signals, concentration risks, and the recent shift in interest rate expectations, all within a market that, while hitting record highs, potentially overlooking forthcoming challenges.
As uncertainties persist, staying vigilant, agile, and open to contrarian opportunities becomes paramount. The delicate balance between fear and greed continues to shape the market’s trajectory, highlighting the need for investors to adapt to the ever-evolving landscape.
Craig Basinger is the Chief Market Strategist at Purpose Investments Inc. and portfolio manager of several Purpose funds, including Purpose Tactical Thematic Fund. Derek Benedet, Portfolio Manager at Purpose Investments, and Brett Gustafson, Analyst at Purpose Investments, contributed to this article.
Notes and disclaimer
Content copyright © 2024 by Purpose Investments Inc. All rights reserved. Reproduction in whole or in part by any means without prior written permission is prohibited. This article first appeared on the “Market Ethos” page of the Purpose Investments’ website. Used with permission.
Charts are sourced from Bloomberg unless otherwise noted.
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