Put an Asterisk by Those Second-Quarter Results

Second-quarter earnings season has been unusual. Consider these observations made last Friday by Refinitiv senior research analyst Tajinder Dhillon about the results reported by S&P 500 index companies (using I/B/E/S data from Refinitiv):

• The current 21Q2 earnings growth rate is the highest since 2009 Q4. 
• 87.4% reported earnings above analyst expectations. This is the highest on record (since 1994).
• 87.0% reported revenues above analyst expectations. This is the highest on record (since 2002).

The positive surprises and strong growth are not limited to large-cap companies. We’re noticing similar trends in mid-cap and small-cap companies as well. Corporate revenues and earnings are bouncing back, and analysts have underestimated how good the year-over-year comparisons are.

AAII president John Bajkowski addressed this phenomenon in his latest Model Shadow Stock Portfolio Update, which was published last week. I’m going to share his insights here because they provide color to the trends we’re seeing.

Year-Over-Year Comparisons Are Nothing Near Normal

Normally looking at year-over-year quarterly results as opposed to a sequential quarterly comparison helps to account for the typical seasonal swings that occur over the course of the year. A year-over-year comparison should help reveal the direction and strength of the company’s growth and the effectiveness of management.

Of course, the last year and a half have been nothing near normal. The impact of the coronavirus pandemic was strongly felt in the second quarter of 2020. This year, as companies report second-quarter results, we are seeing extremely strong year-over-year comparisons. For the most recent quarter, the average year-over-year revenue growth is 37.5%, while the average year-over-year earnings per share increase is 99.2% for the stocks currently in the Model Shadow Stock Portfolio. The median (or midpoint) value that helps to alleviate the impact of extreme numbers observed with averages is very similar. The median year-over-year quarterly revenue growth is 25.5%, while the median earnings per share growth is still 99.2%.

For the same stocks currently in the Model Shadow Stock Portfolio, last year for the second quarter they were reporting a drop in revenue of 15.1% on average (11.7% median) year-over-year and a decrease in earnings per share of 42.6% on average (26.2% median) compared to the second quarter of 2019.

Similar results can be observed by most stocks. For example, the stocks in the S&P 500 index have averaged a 37.9% year-over-year gain in revenue for the most recently reported quarter this year compared to a decline of 10.2% year-over-year last year. As you may have noted, changes in earnings per share have been even more dramatic. With companies in the S&P 500 reporting an earnings gain of 107.8% average (62.7% median) year-over-year for the most recent quarter compared to a decline of 46.5% average (19.9% median) last year.

The coronavirus pandemic created a sudden and extreme decline in economic activity last year. As companies reported poor results, a number of Model Shadow Stock Portfolio holdings were placed on earnings probation. Other shadow stocks were suddenly showing losses under generally accepted accounting principles (GAAP) but also supplied adjusted earnings that were positive because nonrecurring events were excluded from the calculation. We are now seeing the Model Shadow Stock Portfolio holdings coming off earnings probation and notes are being removed regarding the disparity between adjusted earnings and GAAP earnings.

There are many factors influencing the economy and the market beyond the coronavirus, yet the virus continues to strongly influence economic behavior globally and, in turn, the stock market. The highly contagious delta variant is throwing a monkey wrench into the post-pandemic reopening plans of many institutions. Counties that were able to contain the spread of coronavirus with strict social distancing and quarantine mandates now find themselves dealing with strong outbreaks. It serves as a reminder that it is the unexpected events and news that make major impacts on the market, as millions of market participants suddenly change their opinion of likely future outcomes. As former U.S. Defense Secretary Donald Rumsfeld famously noted, it is the unknown unknowns that drive the biggest surprises when they are revealed. The unknown unknowns are the things that we are neither aware of nor understand yet will come to impact us: “There are known knowns; there are things we know we know. We also know there are known unknowns; that is to say we know there are some things we do not know. But there are also unknown unknowns—the ones we don’t know we don’t know.”