Tag Archive: estimates

Tech fundamentals still favor Hardware over Software

While the Technology sector has been less dominant in terms of returns this year than it was last year, it remains the largest sector in the US market by value and the focus of much investor attention.

Our view within the Technology sector for some time now has been to favor hardware-related industries over software-related or services areas, and the latest update of both bottom-up and top-down indicators continues to support this view.

The table below shows some of the key bottom-up fundamental metrics we track for all sectors and industries, and focuses on the six US Technology sector industries (using the GICS industry classifications) within our broad 2300-stock US universe.

The revisions breadth measures shown in the table are based on the proportion of analysts covering each stock who have raised their earnings estimates over the last three months net of those who have lowered earnings estimates. That is, the number of upward revisions to estimates minus the number of downward revisions relative to the total number of analysts covering a stock. We use a weighted average of estimates for each company’s current fiscal year (2021 for most companies right now) and next year (2022) to calculate a consistent 12-month forward earnings figure.

Source: Mill Street Research, Factset

The first column shows the average breadth reading for all stocks in each industry on an equal-weighted (“EW”) basis, while the second column shows the same data on a cap-weighted (“CW”) basis. Naturally, the cap-weighted figures give much more weight to the largest stocks in each industry, while the equal-weighted figures will be relatively more tilted toward smaller names. All stocks in our US universe require a minimum market capitalization of $200 million and at least three analysts reporting estimates, among other criteria, so there are no micro-caps or stocks with very few analysts included.

A few key points jump out from the table:

  • Revisions remain net positive in most areas of Technology, in line with the broadly positive revisions activity in US stocks overall.
  • The average revisions breadth readings on a cap-weighted basis are higher in every industry than the equal-weighted readings, and often much higher. The sector-wide average of about 51% far exceeds the equal-weighted average of about 19%. This means the largest Tech stocks have much more positive analyst activity than the average stock in the sector, i.e., a big-cap bias.
  • The strongest industries are those which focus on hardware right now, while software and services industries are substantially weaker.

We see that on an equal-weighted basis, the Technology Hardware, Storage & Peripherals industry has the highest proportion of positive revisions, followed closely by Electronic Equipment, Instruments & Components and then Semiconductors & Semiconductor Equipment. All three of these hardware-related industries also have the highest revisions breadth on a cap-weighted basis.

At the bottom of the list we see the large Software industry, which has marginally negative net revisions breadth on an equal-weighted basis. This means the average Software stock has a roughly equal number of analysts raising versus lowering estimates. However, on a cap-weighted basis, the revisions figure is strongly positive. This means that a few mega-cap names in the industry have strong revisions, while the majority of mid- and smaller-cap names have relatively weak revisions.

A similar but less dramatic picture is seen in IT Services, where revisions are much lower than in the hardware related industries on both equal-weighted and cap-weighted metrics. The cap-weighted figure is still higher than the equal-weighted, as it is for all Tech industries, but by a much smaller margin than in Software.

The overall picture from the bottom-up, stock level analyst revisions data is that hardware makers continue to surprise analysts positively across large and smaller companies alike, while providers of software and tech-related services are much more mixed and dominated by the largest names in those areas.

The second chart below provides some macro, top-down context for the bottom-up fundamentals we see. The top section of the chart plots the year-on-year percent changes in aggregate spending on investment in computer hardware (blue line) and in software (red line) over the last 30 years. The data come from the quarterly GDP data produced by the US Bureau of Economic Analysis. As of the end of 2020, the growth rate of investment in computer hardware had jumped to 16%, the highest reading since the previous recessionary rebound in 2009-10. Growth in software investment spending, by contrast, had only grown 5%, which is near the lower end of its recent historical range.

Source: Mill Street Research, Bureau of Economic Analysis

The bottom section of the chart plots the ratio of software to hardware spending over time. We see that the line has tended to rise, indicating higher growth in software spending than hardware spending on average over the long run. But the latest readings show a drop, reflecting the jump back toward hardware spending that occurred last year and likely is still ongoing. In the longer-term, it seems likely that software spending will again resume its higher growth rate versus hardware, but the preference for hardware is still very visible in current analyst earnings forecast behavior and could last a while longer as the world continues to adapt to the post-COVID landscape.

Semis vs Software trade now favors Semis

Within the broad Technology sector, there are often significant divergences among the various industries. A key intra-sector industry relationship that many investors use as a touchstone is the relative performance of Semiconductors versus Software.

These two industries capture different parts of the Technology ecosystem. Due to their widespread use in so many devices and products, the Semiconductors and Semiconductor Equipment industry reflects demand for hardware, both within Technology (servers, PCs, phones) and in other sectors (e.g. autos), and thus tends to be much more cyclical. Software tends to be much more stable, with more recurring revenue, and nowadays is closer to a service-type industry. There is much less chance of major “shortages” or “oversupply” of software of the kind that semiconductor makers must often deal with.

So even though software and semiconductors are complementary products (each requires the other), it is not hard to see that they can often have significantly different fundamentals and relative returns on an intermediate-term basis.

Our indicators currently show a growing shift in favor of Semiconductors over Software, both in fundamental earnings trends and relative returns. This is a reversal of the trend seen in the 2017-2019 period, when Semis lagged Software, and much of 2020 when relative performance was mixed.

The chart below shows the strong relationship between relative earnings estimate revisions activity in the two industries and their relative returns. The data are drawn from our broad US stock universe of about 2300 stocks (roughly, all US stocks with at least $200 million market cap and three analysts reporting estimates), and the constituents of each industry are equal-weighted in both the revisions and return series. The return series uses a five-day moving average to show the trends more clearly. Earnings estimate revisions breadth measures the average net proportion of analysts raising versus lowering estimates for each stock. Readings above zero mean more analysts raising estimates than lowering them on average.

US Semiconductors vs Software Revisions and Returns

We see that Semiconductor revisions breadth began losing its relative strength versus Software back in 2017, and continued through early 2019. At that point, Semiconductor revisions started to recover while Software continued a slow deterioration, allowing the relative revisions spread (middle section) to turn up from very negative (i.e., pro-Software) readings. That spread turned positive (favoring Semiconductors) in early 2020, just before COVID-19 hit, and then weakened again as many industries weakened simultaneously in the spring.  Both industries then had a simultaneous sharp rebound, along with most of the rest of the market, through the fall.

The last few months are where we again see a distinct divergence. Software revisions have clearly been losing momentum since September while those of Semis have held up and actually grown somewhat stronger. The spread is now quite wide and at multi-year highs in favor of Semis.

The bottom section of the chart shows the relative returns of the two industries, and we see the clear tendency for relative returns to follow the relative revisions. The relative return series has recently broken out of the range it inhabited for most of 2020, and looks set to follow the relative revisions higher. This suggests that Semiconductors should continue to outperform Software as long as the relative earnings indicators maintain their recent clear bias toward Semis.

US earnings estimate revisions trends remain strong amid Q4 earnings season

While certain heavily shorted stocks are getting much of the attention lately due to retail-driven price surges, the bigger picture news is Q4 earnings reports and analyst behavior.

We track earnings estimates for a broad universe of about 2300 US stocks (market cap of $200 million and up) and construct estimate revisions indicators using two key metrics: breadth and magnitude. Breadth is the net proportion of analysts raising versus lowering estimates for a stock, which is -100% if all analysts are cutting their earnings estimates and +100% if all are raising estimates (0 indicates a balance between positive and negative revisions, or no activity at all). We look at this proportion based on revisions that occurred over the last 100 calendar days (about one quarterly reporting cycle).

Magnitude is the size of the changes, measured as the percent change in consensus mean earnings (EPS) estimates over the past month. It will thus be more sensitive but also more volatile.

The first chart below shows the average daily readings of those two indicators for all US stocks. The red line is the average revisions breadth and the blue bars are the average revisions magnitude. We can see that revisions breadth is holding at very high levels (the long-run average is actually slightly negative because analysts tend to start off with high estimates and trim them as time goes on). This means that a solid majority of stocks have more analysts raising than cutting their estimates for earnings over the next 12 months, and this has been the case consistently since July.

United States_AbsERS_Daily_20210126

The blue bars are now starting to rise again, and we can clearly see the quarterly reporting cycle in the data. The earnings season for Q2 2020 earnings that started last July provoked a big upswing in revisions magnitudes (due to a high proportion of earnings reports beating consensus estimates), and then the reports for Q3 2020 earnings three months later also provoked a similar jump in estimates.

Right now, we see what looks like a third consecutive acceleration in estimate revisions developing as Q4 2020 earnings are now being reported, and are mostly coming in better than consensus expectations. So even after months of analysts raising estimates, they are still being surprised positively by the actual earnings reports.

Where are revisions strongest? The table below shows the average revisions breadth readings for the 11 GICS sectors in the US (using the same broad universe of stocks). We see that Financials is at the top, with a very high reading of over 50%. While Financials have had strong revisions for a while now, the latest jump is likely because Financials are among the first to report earnings in a given quarter and most have reported positive surprises so far: 30 of the 34 Financials in the S&P 500 which have reported so far have beaten consensus estimates for Q4. Analysts often then respond to “earnings beats” by raising estimates for future quarters.

US Sector Abs Rev Breadth tableBeyond Financials, it is still mostly cyclical areas that have the strongest revisions activity, including Industrials, Consumer Discretionary, Technology, and Materials. And while all sectors have net positive revisions breadth, the weakest by a considerable margin are Real Estate, Utilities, and Health Care.

So the message from analysts continues to be strongly favorable for future earnings expectations, even after two consecutive quarters when earnings beat expectations substantially. The macro influences of fiscal and monetary policy on corporate earnings are now well established and likely being embedded in analyst forecasts. This is clear from the relative strength in the cyclical sector revisions indicators.

While equity markets have jumped sharply over the last three months and potentially priced in a lot of good news, the positive trend in earnings estimates from analysts that has supported equity prices thus far looks to be intact for now.

Politics aside, earnings estimates are still improving

While the headlines and market reactions are dominated by the US election results right now, it is worth keeping in mind the news on corporate earnings trends. More than 75% of companies have now reported Q3 earnings, and the results have been extremely strong relative to expectations. The results have not, however, been immediately greeted with positive price responses. Market action being attributed to the election may also be influenced by a lagged response to earnings reports.

According to Factset, within the broad S&P 1500 index universe (large, mid, and small-caps), 84% of companies have reported positive surprises (earnings ahead of consensus estimates) for Q3 so far, and the average “beat” has been quite large in percentage terms. Whereas the consensus forecasts expected S&P 1500 earnings to be down about -25% from a year prior in Q3 when the quarter started (July 1st), the actual results look like they will be around -8%: still down, but far less than expected.

However, Factset’s calculations indicate that only 48% of stocks had a positive stock price impact immediately after their report. Worries about the election and the prospects for further fiscal stimulus in recent weeks may have dampened investor responses to what would otherwise be favorable corporate earnings news. With some of the political uncertainty in the process of being resolved now, investors may now be willing to reward positive earnings news.

So how are analysts responding to the corporate news flow with regard to their forward earnings estimates for the next 12 months?

Our data show that analysts continue to show significantly more estimate increases than decreases in the US, and increasingly that is true for the lagging developed ex-US (EAFE) universe.

The charts below show our indicators of analyst estimate revisions activity in the US and EAFE markets (Europe, Australasia and Far East, i.e., developed ex-North America markets). The red line is the average net proportion of analysts raising versus lowering earnings estimates (right scale), and the blue bars indicate the average percentage change in next-12-month (NTM) estimates over the last month (left scale).

United States_AbsERS_5Nov2020

EAFE Markets_AbsERS_5Nov2020

We see that the US estimate revisions indicators shifted dramatically from severely negative in the spring amid the initial COVID-19 lockdowns to positive over the summer (starting after Q2 earnings reports) and have recently accelerated further to their highest readings in many years. This reflects the impact of the massive stimulus programs started in April and continued through the summer, but which are now fading. It also reflects the heavily conservative estimates that analysts made amid the extreme uncertainty around the impact of COVID-19 and the lack of corporate earnings guidance: with much less information to go on and plenty of unprecedented events, they took a very cautious view on their earnings estimates. Thanks to stimulus and other measures (forbearance on debt repayments, evictions, etc.), earnings have been better than those pessimistic estimates.

A similar pattern has played out, to a somewhat lesser extent, outside the US, where growth was already somewhat weaker than in the US and stimulus efforts were more mixed. This is partly due to the issues in Europe where coordinated fiscal policy is more difficult to do, and the fact that interest rates were already zero or negative in most of the region and thus couldn’t be lowered much more. The same is true to some degree in Japan. And while the US election will be resolved one way or another in the coming days and weeks, the impact of Brexit on the UK and Europe remains an ongoing risk factor.

The recent trend in analyst estimate activity thus remains favorable, but faces risks from the current upswing in COVID-19 cases in the US and Europe as well as the timing and scope of any further fiscal support for economies. Thus choppy market action with an upward drift continues to look most likely, with significant rotation under the surface of the major indices.

Tech Sector In The Driver’s Seat For US Relative Performance

In this post, we highlight the interaction of US outperformance versus the rest of the world this year and US Technology relative to Ex-US Technology.

  • First, the relative performance of the US equity market versus the rest of the world has been highly correlated with the relative performance of US Technology stocks relative to Ex-US Technology stocks.
  • Second, the outperformance of US Technology, and by extension the major US indices versus their non-US counterparts, looks likely to continue based on relative earnings estimate revisions patterns.

The chart below supports our first point. The US has outperformed the rest of the world this year by a healthy margin, based on the MSCI regional benchmark indices, as shown in the top section (plotted using rolling five-day averages). The lower section isolates the Technology sectors for the US and the Ex-US universe (also using MSCI indices) and plots the relative return of the US versus Ex-US Technology sectors.

US vs Ex US and Technology Relative Returns

We can see the close parallels in the charts for the year-to-date: as US Tech outperforms Ex-US Tech, so does the broader US market outperform the Ex-US aggregate. This in some ways seems unsurprising given the heavy weight that the Tech sector holds in the US compared to many non-US markets, but the relative weights are unrelated to the relative performance of the US versus Ex-US Tech sectors. We find that even after removing the effects of sector weightings, US stocks have outperformed Ex-US stocks this year, and this effect is particularly strong within the Technology sector.

Our second point is captured in the chart below. It shows our measure of aggregated earnings estimate revisions (the percentage of analysts raising versus lowering earnings estimates) for the US Tech sector and the entire Global Tech sector (which includes the US).

Technology Sector Revisions Breadth Metrics

We can see here that earlier this year, US and Global Technology estimate revisions (fundamental trends) were mostly moving closely together and slightly favored non-US Tech (US Tech revisions were slightly weaker than Global Tech revisions).  Both revision metrics improved sharply from the April lows through today. But the difference between the US and the Global Technology sector earnings estimate measures moved dramatically in favor of the US in July after Q2 earnings reports came out, and have generally remained there ever since. This suggests that US Technology stocks have a strong fundamental tailwind relative to Tech stocks outside the US right now. If that US Technology tailwind persists, the broader US market seems likely to resume outperforming the rest of the world in the coming months.

Is the rebound in earnings estimate revisions peaking?

Our measures of aggregated earnings estimate revisions trends have shown some of their most dramatic movements on record this year, and now may be looking extended.

After reaching historically extreme negative readings in April/May amid the initial COVID-19 lockdowns, earnings estimate revisions activity has now lurched back up to extremely positive readings. Better-than-expected Q2 earnings reports and the effects of massive monetary and fiscal stimulus are now finally reflected in analyst earnings forecasts. However, with fiscal stimulus weakening (and little imminent sign of movement toward new stimulus) and no meaningful further scope for interest rate cuts, the “snap-back” in earnings estimate activity could soon drop off.

The first chart below shows our measure of aggregated analyst earnings estimate revision activity in the US, for our broad universe of over 2000 stocks (equally-weighted) on a longer-term time frame. The data are month-end values except for the latest data point.  The red line represents the “breadth” of estimate revisions, meaning the aggregate net proportion of positive versus negative revisions (changes) to forward 12-month earnings estimates over the prior three months (i.e., number of analysts who have raised earnings forecasts minus the number who have reduced forecasts, as a percentage of the total number of analysts for each stock, scale right). The blue bars represent the “magnitude” of the month-on-month changes in forward 12-month forecasts, i.e., the average percentage change in earnings forecasts from a month ago (scale left).

United States_AbsERS

We can see that the low point in April matched (or exceeded) the extremes seen in the 2008 Great Financial Crisis (GFC) period, which is not surprising given that the drop-off in economic activity this year was greater than in the GFC. However, the combined fiscal and monetary stimulus recently produced in response was also greater than any previous post-WWII period, and so revisions metrics have shown a faster and more extreme rebound than at any previous point in our data. Stock prices appear to have moved ahead of aggregate estimate revisions, raising the question of whether this apparent good news for earnings is already priced in.

Perhaps more concerning is the risk that revisions (i.e., analyst sentiment) have reached highly optimistic readings now and may already be starting to revert. The chart below is calculated identically to the one above, but plots the daily figures (rather than monthly) over the last three years. Here we can see that the blue bars are already coming down from their latest peak, suggesting that the upward momentum of earnings estimate revisions may be fading now that Q2 earnings reports are over. The breadth series (red line) is based on revisions over the last three months, so it encompasses a full calendar quarter and is thus more stable. If revisions breadth starts to turn down (as it did after the tax-cut surge in early 2018) alongside current elevated valuations for equities, then the recent signs of higher stock market volatility could persist into Q4.

United States_AbsERS_Daily

Earnings uncertainty still extremely high going into Q2 reporting season

July 10, 2020

As Q2 earnings season gets underway, the level of uncertainty about future earnings among analysts remains extremely high. Despite somewhat calmer equity market activity recently, our data shows that the level of disagreement among analysts regarding earnings over the next 12 months (NTM) is still well above the highest levels reached in the Great Financial Crisis (2008-09) period (chart below).

US Estimate Disperson

The chart plots monthly (and latest) readings for the average dispersion of analyst forecasts around the mean for US stocks (standard deviation of estimates as a percentage of the mean estimate for each stock, averaged across all stocks in our 2300-stock US universe*). A higher dispersion number indicates a wider range of estimates (more disagreement about the level of future earnings) for the average stock. The solid horizontal line is the long-run average, and the dashed lines are +/- 1 standard deviation from the average.

One reason for the extreme level of disagreement among analysts is that a record number of companies have withdrawn their usual earnings guidance in light of the uncertainty surrounding the impact of COVID-19 and related government responses.

And equity analysts, like many other workers, have also been forced to work from home and unable to travel to visit companies, attend conferences, and gather information as they normally would. So with less scope to do their own legwork and less input from company management, analysts have far less information to work with now than usual.

These limitations on information access, alongside the obvious difficulty of predicting economic activity and earnings in an unprecedented global health crisis, no doubt help explain why there is little confidence about forecasting future earnings. We might therefore expect to see a greater number of earnings surprises when companies release their results.

And while theory suggests that higher earnings uncertainty would normally prompt investors to reduce the valuations given to equities, that has not been the case recently as aggressive stimulus from central banks and government spending have in fact pushed equity valuations much higher.

*Note: our US universe includes stocks with at least three analysts covering them, a minimum $200 million market cap, and at least $2 million/day average trading volume.