Lofty Earnings Estimates, Rising Treasury Yields Are Hurdles To Clear
October 2021
From a seasonality perspective, October has historically ushered in more profitable days for equity investors as the 4th quarter of any given calendar year has, on average, been the best of the bunch for the S&P 500. Throughout history, however, October has also developed a reputation for occasionally being quite scary, and we’re not just talking about Halloween. The “October effect” is the perception that stocks typically fall during the month, but this is a purely psychological phenomenon as, dating back to 1928, the S&P 500 has ended October higher 58% of the time, and by an average of 4.1%. The belief that October is pre-destined to be a challenging one for equity investors is likely rooted in the fact that October has, not once, but twice, contained a “Black Monday.” The first being in 1929 and the second in 1987, with October 19 of 1987 providing the largest single-day decline in the Dow Jones Industrial Average on record at over 22%. While we don’t expect this month to be a repeat of ‘29 or ‘87, September’s challenging backdrop for U.S. equities could stretch into October for two reasons: lofty quarterly earnings expectations and the potential for long-term Treasury yields to move higher into year-end amid stickier inflationary pressures.
On the earnings front, estimates for the 3rd quarter have remained anchored, with the analyst consensus estimate for quarterly S&P 500 earnings sitting at $48.36 on September 30, down just $0.30 since the end of August. This despite some blue-chip companies already posting quarterly results that fell short of estimates, while also lowering or removing forward guidance due to higher labor costs and/or supply chain bottlenecks. The current backdrop isn’t set up for an ‘under promise and overdeliver’ quarter in our view, and earnings expectations that fail to be met or exceeded could lead to steeper near-term drawdowns. A positioning or sentiment reset, while painful, would be healthy and provide investors with a more appealing opportunity set as we enter a historically positive seasonal stretch from mid-October through December and year-end performance chasing boosts demand for year-to-date ‘winners.’
After peaking at 1.74% on March 31, the U.S. 10-year Treasury yield ended each calendar month from April through July lower than the prior month’s close, a tailwind for growth stocks. Long-term Treasury yields remained range-bound throughout August, the 10-year yield, specifically, closing between 1.20% and 1.35% on all but a few days during the month – again, a constructive backdrop for growth. However, the supportive interest rate backdrop for growth sectors in place from April through August shifted after the Federal Open Market Committee’s (FOMC) September meeting concluded on the 22nd. Post-meeting, FOMC Chair Jerome Powell acknowledged that inflationary pressures would be stickier than expected, leading to fears that the Fed could be ‘behind the curve’ when it comes to battling inflation.
Fears that persistent inflation could force a faster tapering of bond purchases or potentially pull forward Fed fund rate hikes led to increased short positions in long dated U.S. Treasuries, or bets that yields would rise, which pushed the 10-year U.S. Treasury yield higher by 20 basis points over the final seven trading days of September. The possibility that the FOMC might need to get more aggressive to combat inflation spurred sector rotation to close out the quarter. Investors used information technology as a source of funds and reallocated capital into energy, materials, and financial services to position for persistent inflation or a further rise in long-term Treasury yields. Despite this shift, our portfolios remain balanced between growth and value as economically sensitive sectors may be the place to be near-term as inflation expectations remain elevated, but once Treasury yields/inflation expectations stabilize, growth sectors should once again garner interest as CFO’s seeking the biggest productivity bang for their buck will be hard-pressed to find a better place in which to deploy capital.
Outside the U.S., investors are focused on the evolving regulatory backdrop in China, as well as on how the Evergrande situation plays out amid chatter that the Chinese government could force a break-up of the beleaguered real estate developer to prevent economic contagion. Statements such as “China is un-investable” make the contrarian in us question if a bottom is near, but we acknowledge that this situation isn’t likely to be resolved soon and remain neutral on emerging market equities as a result. We remain positive on Europe as economic growth expectations are reasonable and indices skew ‘cyclical’ providing leverage to a global economic recovery. The European Central Bank (ECB) is expected to keep pandemic-era support in place for longer than the FOMC and the Bank of England; however, higher inflation readings out of the Eurozone will test the ECB’s ability to remain accommodative. We expect October to be volatile as investors parse earnings releases and digest higher energy prices, but liquidity and economic recovery should propel stocks higher over the coming year and we continue to view pullbacks as buying opportunities.
Source: Bloomberg, Factset, Yardeni Research
