Business As Usual: Companies Are Crushing Earnings. So Why Are Their Stocks Dropping?”

Richard Falvo, Staff Writer

Thanks to diligent vaccination efforts, developed economies around the world have continued to ramp up reopening efforts, thus signaling a sense of optimism to governments and citizens, as well as financial markets. This is especially true in the United States, where 28.5% of the total population has been fully vaccinated, according to data from the Centers for Disease Control and Prevention (CDC) as of April 25, 2021. Of course, this rate will continue to rise as second doses are administered and more individuals are granted eligibility to be vaccinated. One would think that such developments would cause stocks to move substantially higher. However, with many companies having released financial data for the first quarter of 2021, an interesting phenomenon has taken place: companies reporting spectacular results are seeing their stock move lower after the announcement. Why would that be?

The answer lies at the heart of what financial markets are designed to do: price in future expectations and react accordingly to deviations from such expectations. On any given day, a seemingly limitless supply of information is made available to billions of people around the globe. In fact, this mechanism has become even more efficient with the advent of the Internet and high-frequency trading. As a result, traditional stock-picking has become increasingly more difficult. After all, if more information is readily available in quicker fashion, then the window of opportunity to act and profit on potentially valuable information before the market can react begins to close quickly. 

Since the S&P 500, one of the most closely-followed gauges of the United States stock market, bottomed in March 2020, it has increased over 81%. The tech-heavy NASDAQ Composite has more than doubled over the same period. Many have questioned the meteoric rise in stock prices, especially since most of the gains took place before any vaccines had been made available. However, when considering the function outlined above, it becomes clear that markets have simply priced in many of the factors associated with a return to normalcy, including recoveries in labor markets, supply chains and the broader economy as a whole. In other words, the stock market has already taken into account much of what people expect to take place in the future.

This is especially true on the corporate earnings front. Every three months, companies release updated financial information pertaining to operations and developments over the past fiscal quarter. In addition, companies provide guidance as to the financial figures investors can expect to see in upcoming earnings announcements. As the pandemic unfolded, it became clear that while earnings figures for 2020 would be abysmal, a sharp recovery would take place the following year. According to estimates from Yardeni Research, earnings for S&P 500 companies in Q1 2021 were expected to grow by 27.2% on a year-over-year basis. These forecasts were calculated on March 29, before companies began to report actual earnings for that fiscal quarter. It is worth noting that many other research outlets projected similar expectations as Yardeni, including FactSet and Bloomberg.

Fast forwarding to today, about one quarter of S&P 500 companies have reported Q1 2021 earnings. However, even though many of those companies released earnings that topped analyst expectations, stocks are not reacting strongly. According to FactSet, “Overall, 25% of the companies in the S&P 500 have reported actual results for Q1 2021 to date. Of these companies,

84% have reported actual EPS above estimates, which is above the five-year average of 74%.” Furthermore, “Companies that have reported positive earnings surprises for Q1 2021 have seen an average price increase of +0.4% two days before the earnings release through two days after the earnings release.” For reference, “EPS” stands for “earnings per share,” which is simply a measure of a company’s profits divided by the number of shares outstanding.

Evident from the data collected by FactSet, share prices are not reacting in particularly strong fashion to earnings reports, even though those reports contain outstanding performance data. As Yun Li writes at CNBC, “It shows the bar is particularly high for earnings to lift stocks higher after an impressive rally to record highs this year.” This set of circumstances should act as a reminder to investors who seek to turn a quick profit on the back-end of positive earnings reports that, in periods of immense market euphoria, a substantial amount of good news has already been baked into the cake in the short-run. This is why it is crucial to understand the functional dynamics of markets prior to entering it.