The U.S. equity market has continued to drift higher despite a wall of worry: delta variant headwinds, the recent plunge in Treasury yields, ongoing inflation and supply chain challenges, and uncertainties about the economic recovery.

Is the market being complacent? No, not if you consider the great motivator: profits.

Investors seem more focused on what truly makes the market tick over the long run—corporate profit growth. The unusually strong Q2 earnings season and constructive outlooks from management teams have helped the S&P 500 inch up to a new all-time high. With 85 percent of S&P 500 companies having reported results so far, Q2 earnings growth is at an impressive 93 percent year-over-year.

Earnings growth estimates have risen for Q2 2021 and the three subsequent quarters
Consensus estimates of S&P 500 quarterly earnings growth (all data is year-over-year %)
Line chart of performance of U.S. Russell 1000 Value Index vs. Growth Index

The bar chart shows that during the earnings reporting season, consensus earnings growth estimates have risen from July 2 to August 3 as follows: for Q2 2021 from 65.4% to 92.9%; for Q3 2021 from 24.7% to 29.8%; for Q4 2021 from 17.3% to 21.5%; for Q1 2022 from 2.9% to 4.8%.

Consensus estimate on July 2

Consensus estimate on August 5

Source - RBC Wealth Management, Refinitiv I/B/E/S; data through 8/5/21 with 85% of companies having reported Q2 earnings so far

Granted, much of this is due to “easy” COVID-19 comparisons. During the pandemic’s first wave when the economy was mostly shuttered, S&P 500 profits fell sharply by 31 percent in Q2 2020, the period the current earnings season is measured against. And with the economy now largely open and many households with extra cash to spend from stimulus checks, corporate profits have bounced back significantly from that ultralow level.

But this is not the full story. A meaningful portion of the Q2 boost is because the release of pent-up demand for goods and services has been more robust than many Wall Street analysts and corporate executives initially projected. Heading into this reporting season, the Q2 consensus forecast was for lofty 65 percent year-over-year earnings growth. The current 93 percent rate is far higher than even the highest estimates were at the time.

Furthermore, the proportion of companies beating Q2 consensus earnings and revenue estimates is at its highest level going back to at least 2004. Also, the magnitude of earnings beats is elevated, and the magnitude of revenue beats is at a cycle high, as the charts illustrate.

Earnings surprises strong, but below the recent peak
Magnitude of historical and current EPS surprises

The bar chart shows that from Q2 2016 through Q1 2020, earnings per share surprises (EPS) averaged 5.2% each quarter. During the COVID-19 crisis, EPS surprises jumped dramatically. During the past five quarters, they have averaged 19.1%, including the Q2 2021 preliminary data of 16.1%.

Revenue surprises have hit a multiyear high
Magnitude of historical and current revenue surprises
Donut chart of Russell 1000 Growth Index sector breakdown

The bar chart shows that from Q2 2016 through Q1 2020, revenue surprises averaged 0.9% each quarter. During the COVID-19 crisis, revenue surprises jumped dramatically. During the past five quarters, they have averaged 3.4%, including the Q2 2021 preliminary data of 4.6%.

Source - National research correspondent, Refinitiv I/B/E/S, FactSet; Q2 2021 data (in blue) is preliminary as of 8/4/21 and is subject to change as more companies report earnings

All of this has led to Q2 2021 earnings being 24 percent higher than the pre-COVID-19 level in Q2 2019—an impressive feat that was unthinkable at this time last year.

“Peak growth” isn’t the be-all and end-all

Even though we are confident that this torrid pace will be as good as it gets for this business cycle, we expect S&P 500 profits to rise further in 2022, albeit at a more normal rate. In other words, Q2 2021 earnings should represent the peak year-over-year earnings growth rate but not the peak level of earnings for this expansion cycle.

This is an important distinction because bear market periods typically occur alongside a persistent, meaningful decline in the level of earnings as recession risks become palpable. At this stage, all six of our recession indicators are flashing green, so these risks are nearly nonexistent and are unlikely to change much over the near term, in our view—barring another outside shock to the system.

But we think the range of potential 2022 earnings outcomes is wide. During this extremely unusual period, it seems many economists and a lot of management teams are having just as much difficulty forecasting the magnitude of the recovery as they did during the initial COVID-19 downturn.

This is due to lingering COVID-19-related challenges and the uncertainties about the strength and quarter-by-quarter shape of economic growth, which could be less than or greater than current forecasts. The Q2 earnings season provides further evidence that high inflation levels, tight labor supply and wage pressures, and supply chain disruptions are generally manageable. But they are posing challenges for some companies, and it is unclear how long these headwinds will persist.

The consensus S&P 500 earnings forecast for 2022 has moved up to $219 from $214 per share in the past month, according to Refinitiv I/B/E/S. This would represent 9.3 percent year-over-year growth. We would take this estimate with a grain of salt given the unique forecasting challenges, and because most corporate management teams have not yet provided their 2022 estimates and Wall Street analysts have not yet sharpened their earnings models for next year.

The ability to cope

We remain constructive on U.S. equities because the headwinds seem manageable in light of our recession indicators, and the market’s great motivator—profit growth—is sending the right signals.

But a market pause or pullback would be normal. RBC Capital Markets, LLC’s head of U.S. Equity Strategy Lori Calvasina points out that periods of peak earnings growth are often accompanied by a loss of price momentum for the market. In the early stage of the past three bull market cycles going back to 1993, the S&P 500 declined by a range of one percent to 7.6 percent in the six months following the peak rate of earnings growth.

The effect was temporary, as the S&P 500 eventually resumed its upward trajectory in each of the three instances, climbing a total of 26 percent to 50 percent during the 36-month period following the peak in earnings growth. The market continued to rally largely because the economic expansions persisted and the absolute level of earnings continued to march higher, albeit at a slower pace. We think a similar earnings growth pattern will play out this business cycle.

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