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Can the Rally Continue?

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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 during the pandemic cementing that role. Some inflation worries entered the discourse this year as the Biden administration’s expansive policy platform took shape. This caused long-term treasury yields to modestly move up, though they have partially retraced their steps more recently.

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 talk, but it does mean that we can have full confidence in the Fed’s ‘pricing-pressures-are-transitory’ outlook, which should keep interest rates low for an extended period.

Unlike interest rates, the earnings picture took a severe beating as a result of the pandemic, with activities related to the broader leisure, hospitality and travel spaces particularly hard hit.

Widespread vaccinations have materially brightened the outlook for these activities domestically, though the ongoing spread of the Delta variant is adding some uncertainty to the outlook.

The much bigger uncertainty is about regions beyond the U.S. borders that have far smaller proportions of their populations immunized and are forced to institute fresh restrictions in the face of the Delta outbreak. The concern is that this fresh outbreak comes in the way of the expected global economic rebound and serves as a brake on the accelerating earnings growth outlook.

Earnings growth remains very strong, with the ongoing 2021 Q2 earnings season on track to show growth in excess +75%. The growth pace is expected to decelerate in 2021 Q3 and beyond, but still remain very strong by historical standards. This would come after the COVID-19-driven declines of 2020 when earnings dropped by more than -13%.

Continued . . .

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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 the hard-hit sectors expected to earn 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 remain positive to help sustain the rally.

These are all reasonable points – earnings growth this year is benefiting from easy comparisons and the market’s gains thus far 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 the full extent of the economic reopening takes hold.

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 third quarter of 2021 have been steadily going up, with the current +24.2% earnings growth rate up from +22% on June 30th and +17.1% at the end of March.

Granted, the positive revisions to 2021 Q3 estimates isn’t the first instance of such favorable revisions, as this trend has been in place since last Summer. But this revisions trend is nevertheless in contrast to comparable periods over the last many years when estimates would actually be going down at this stage.

We are seeing a similar favorable revisions trend for estimates for full-year 2022 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 12 of the 16 Zacks sectors since the start of the year, with the biggest gains in the Energy, Basic Materials, Construction, and Finance sectors. The only sectors that have suffered modest negative revisions include Transportation, Consumer Discretionary, Aerospace and Utilities.

The next point will make the case for the revisions trend to accelerate meaningfully in the coming months as the vaccines help us put the pandemic behind us, even as the pathogen continues to circulate among us.

The fact is that there is no fundamental reason for the rally to lose ground as long as interest rates remain stable and earnings estimates maintain their current uptrend.

Third: Current 2021 consensus earnings growth expectations for the S&P 500 index of +38.6% reflect a macroeconomic view that has lately come under pressure as a result of the Delta outbreak, with U.S. GDP growth projected to be in the +6% to +7% range this year and north of +3% next year.

These economic growth estimates largely reflect how the U.S. economy has historically behaved in coming out of economic downturns. 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 given its medical/health origins.

While full-year earnings estimates have gone up, they have yet to reflect the full extent of the post-Covid economic rebound.

The Delta variant remains a hurdle for the broader global economy, but it will most likely be not even a speed bump for the U.S. economy. Some economists have recently trimmed their GDP growth forecasts, but the cuts are very small and will most likely get reversed as they move forward.

The bottom line is that there is significant upside to current consensus earnings estimates. And an environment of rising earnings estimates and stable interest rates should keep stocks on an upward trajectory.

Putting It All Together 

In the ongoing Q2 earnings season, companies are not only coming out with impressive results, but also providing positive guidance for Q3 and beyond.

Current estimates for this year and next represent strong earnings growth, but we remain very confident that the growth pace should continue to go up as a 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 in 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.