This is the most challenging earnings season in history. Amidst the covid-19 induced earnings uncertainty, the old tools for trading earnings season won’t work anymore. How can investors adapt?
Investing in a time of suspended earnings guidance
Most publicly traded companies have traditionally provided earnings guidance to help investors forecast near term performance, and estimate company valuation. Although this practice is far from perfect, many investors rely on it in order to build forecast models and make decisions. Yet management teams at most companies have no way of predicting how long the current pandemic will last, or how deep the impact will be on their business. Consequently, according to IR Magazine, at least 341 companies suspended annual guidance between March 16, and April 12.
Sell side analysts are also flying blind. According to Jonathan Golub, chief U.S. equity strategist at Credit Suisse.
While analysts are updating their numbers much more frequently than normal, their estimates remain stale. This pattern will likely continue until the start of earnings season, and beyond.
Indeed, there is a wide range of possibilities for earnings for the next few quarters:
How long, and how deep?
The value of a company comes from long run earnings guidance. If a company avoids near term solvency and liquidity issues, then one quarter of bad earnings should actually have little impact on If there is only one disastrous quarter, it will have little impact on the fundamental value of the company. Once investors have a better idea of when lock downs will end, they can start to focus on potential rebound in earnings. Yet its possible many investors are being overly optimistic.
Mohamed A. El-Erian noted in the Financial Times:
Economists initially — and over optimistically– embraced the idea of a quick second-quarter recovery followed by a more gradual recovery in the subsequent three: a pattern more consistent with the sudden stop to global activity. But current projections still underestimate the severity of the shutdown of the global economy, an inherently messy restart process, and consequent changes to the post-crisis landscape.
JP Morgan has estimated that earnings won’t recover fully until 2023. With no guidance from management, and stale estimates from sell side analysts, the challenge for investors is greater than ever. There is likely to be heightened volatility as investors react to earnings, and attempt to read between the lines when management discuss their business.
With so much of the market flying blind, there is increased value in alternative data sources. Investors need to piece together a variety of disparate sources for real-time economic data. The next few quarters are an opportunity for the best researchers to get an informational edge in estimating company earnings.
The one thing we can guarantee
Amidst all this uncertainty, there is one thing we can be certain about : the stock market will overshoot in both directions in response to news. Although earnings are driven by company performance, earnings multiples will be driven by capital flows and liquidity. Consequently, earnings derivatives are an essential tool in this new environment.