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What Will Be the Rally's Next Catalyst?

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Stocks continue to defy the skeptics, pushing the broad indexes into record territory. But persistent 'correction' chatter isn't going away either, keeping alive questions about the market's next move.

I am adding to that debate in this piece by pointing out a source of support for the market that will help the rally gain strength and longevity.

Stocks need power to push higher, just as humans and machines do. For stocks, this 'power' comes from a variety of sources, but interest rates and corporate profits are the biggest drivers.

Interest rates have been market-friendly for the last many years, with forceful Fed action at the start of the pandemic cementing that role. Some inflation worries have lately entered the discourse that have pushed long-term rates modestly higher, with the potential inflationary effects of the new administration’s expansive fiscal plans as main driver.

Inflation fears aren’t new; they have come and gone regularly over the last many years, particularly since the global financial crisis. But there are valid fundamental arguments that suggest that the ongoing version will likely be no different. This doesn’t mean that we outright dismiss all inflation, but it does mean that we can have full confidence in the Fed’s commitment to keep interest rates low for an extended period.

Unlike interest rates, the earnings picture has been a lot less clear, with the pandemic dealing a severe blow to the profitability of key parts of the economy. The pandemic had a negative bearing on the entire economy, but activities related to the broader leisure and hospitality space were particularly hard hit.

The concern is that many of these businesses will take a long time to get back to pre-COVID-19 profitability levels even as we make headway on the vaccination effort in the coming days.

Earnings growth is expected to resume in the first quarter of 2021, meaningfully accelerate in the following two quarters, and maintain the growth pace thereafter, albeit at a slower pace. This would come after the COVID-19-driven declines of 2020 when earnings dropped by more than -16%.

Many skeptics have been discounting this favorable turn in the earnings growth picture, citing the outsized contribution of easy comparisons for the elevated growth pace this year, with many sectors expected to earn significantly below their pre-COVID-19 levels. This skeptical narrative also refers to the market’s outsized gains during the pandemic as having already discounted this year’s earnings growth. This view argues that given the already stretched level of aggregate valuation metrics, we would need the incremental developments on the earnings front to be positive to help sustain the rally.

These are all reasonable points – earnings growth this year is largely due to easy comparisons and the market’s gains last year anticipated the growth rebound. But that doesn't mean that the earnings picture hasn't improved at all; it has improved in meaningful ways already and the trend will only accelerate as we make progress on the vaccination front and put the pandemic behind us.

Here are the three points in support of this view: 

First: The revisions trend is positive and represents a notable improvement over historical periods. Earnings estimates for the first quarter of 2021 have been steadily going up, with the current +14% earnings growth rate up from +12.6% on January 6th and +11.7% in mid-December.

Granted, the positive revisions to 2021 Q1 estimates isn’t the first instance of such favorable revisions, as this trend has been in place since July 2020. But this revisions trend is nevertheless in contrast to comparable periods over the last many years when estimates would actually be going down.

We are seeing a similar favorable revisions trend for estimates for full-year 2021 as well.

Second: The favorable revisions trend is broad-based and not concentrated in one or just a few sectors. Looking at full-year 2021 earnings estimates, estimates have gone up for 13 of the 16 Zacks sectors since July 2020, with the biggest gains at Energy, Autos, Construction, and Basic Materials sectors. The only sectors that have suffered negative revisions include Transportation, Consumer Discretionary and Aerospace. We are seeing a similar trend at play for Q1 estimates as well.

The next point will make the case for the revisions trend to accelerate meaningfully in the coming months as the vaccination effort reaches a critical mass. But even as we wait to reach that level, there is no fundamental reason for the rally to lose ground as long as earnings estimates are still going up.

More . . .

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Third: Current 2021 consensus earnings growth expectations for the S&P 500 index of +23.7% reflect a macroeconomic view where the U.S. economy is expected to grow by +4%. This economic growth projection reflects how the U.S. economy has historically behaved as it comes out of economic downturns.

But even as these consensus economic growth projections are grounded in a realistic reading of economic history, I am partial to the view that argues for the economy to behave differently coming out of this economic downturn given the medical/health nature of this downturn. Traditional economic downturns that originate in the financial markets tend to weigh on business and household sentiment for much longer than can reasonably be expected to be the case this time around.

This isn’t just my wishful thinking; a number of major Wall Street firms subscribe to this view as well. In fact, Goldman Sachs recently raised its 2021 GDP growth forecast to north of +6%, citing similar reasons. That’s a 50% upside to current consensus economic growth projections that will have implications for earnings outlook as well.

Putting It All Together

Companies are currently reporting results for the last quarter of 2020 when the pandemic was still very much a burden for many parts of the economy. As such, earnings would be down from the year-earlier period, but the decline will be a lot smaller than what we saw in the first three quarters of 2020.

But that’s behind us now. Not only is earnings growth on track to turn positive in 2021 Q1, but the growth pace should continue to go up as result of favorable estimate revisions. In fact, there is a strong likelihood that the outlook for economic and earnings growth will turn out to be a lot stronger than currently reflected in consensus estimates.

The stock market’s positive momentum is grounded in the fundamental reality of an improving earnings outlook and a very favorable interest rate environment. We see no reasons for this trend to stall or reverse as long as these fundamental drivers remain place.

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Thanks and good trading,

Sheraz Mian

Sheraz Mian serves as the Director of Research and manages the entire research department. He also manages the Zacks Focus List and Zacks Top 10 Stocks portfolios. He invites you to access Zacks Investor Collection.

¹ The results listed above are not (or may not be) representative of the performance of all selections made by Zacks Investment Research's newsletter editors and may represent the partial close of a position.