As of today, the S&P 500 is expected to report a decline in earnings of -20.5% for the third quarter. What is the likelihood the index will report an actual decline in earnings of -20.5% for the quarter?
Based on the average change in earnings growth due to companies reporting positive earnings surprises, it is likely the index will still report a year-over-decline in earnings of more than 15% for Q3.
When companies in the S&P 500 report actual earnings above estimates during an earnings season, the overall earnings growth rate for the index increases because the higher actual EPS numbers replace the lower estimated EPS numbers in the calculation of the growth rate. For example, if a company is projected to report EPS of $1.05 compared to year ago EPS of $1.00, the company is projected to report earnings growth of 5%. If the company reports actual EPS of $1.10 (a $0.05 upside earnings surprise compared to the estimate), the actual earnings growth for the company for the quarter is now 10%, five percentage points above the estimated growth rate (10% - 5% = 5%).
Over the past five years on average, actual earnings reported by S&P 500 companies have exceeded estimated earnings by 5.6%. During this same period, 73% of companies in the S&P 500 have reported actual EPS above the mean EPS estimate on average. As a result, from the end of the quarter through the end of the earnings season, the earnings growth rate has typically increased by 3.4 percentage points on average (over the past five years) due to the number and magnitude of positive earnings surprises.
If this average increase is applied to the estimated earnings decline at the end of Q3 (September 30) of -21.0%, the actual earnings decline for the quarter would be -17.6% (-21.0% + 3.4% = -17.6%). If the S&P 500 reports a year-over-year decline in earnings of -17.6%, it would be the second largest year-over-year decline in earnings reported by the index since Q2 2009 (-26.9%), trailing only the previous quarter (-31.6%).
During the second quarter earnings season, there was an unusually high 12.5 percentage point improvement in the earnings decline (to -31.6% from -44.1%) due to a record-high percentage of companies reporting positive EPS surprises (84%) and a record-high positive variance between actual earnings and estimated earnings (+23.1%). Please see our previous article on this topic.
However, this positive performance occurred after analysts made record-high cuts to earnings estimates (-37.0%) during the second quarter. Thus, S&P 500 companies had a much lower bar than normal to clear in Q2 to report positive earnings surprises. Please see our previous article on this topic.
Although analysts lowered Q3 earnings estimates by 23.6% during the second quarter (March 31 to June 30), they actually increased Q3 earnings estimates by 4.1% during the third quarter (June 30 to September 30). Please see our previous article on this topic.
Thus, it will be interesting to watch the performance of actual earnings relative to estimates for Q3 over the next few weeks given the change in net estimate revisions by analysts from negative to positive over the past few months.
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