Earnings > Inertia, At Least For Today

Last month, we posited that the current trends in the stock market are better thought of as inertia, rather than momentum.  A body in motion tends to stay in motion unless acted upon by an external force. So far, there has been a paucity of forces sufficiently powerful to disrupt the forward motion of stock prices.  That said, earlier this week we wondered whether mega-cap tech earnings could be that type of force.  For today, at least, US equity markets do seem to be disrupted by negative reactions to earnings reports from Tesla (TSLA), Netflix (NFLX), and Taiwan Semiconductor (TSM).  All three beat their earnings per share (EPS) expectations but sold off anyway thanks to either weaker guidance or disappointment with other metrics. 

Our primary concern was that the recent run-up in equity prices, propelled almost exclusively by multiple expansion – the willingness of investors to pay higher prices for the same amount of earnings per share – raised the bar for earnings psychology:

Remember, we have seen considerable multiple expansion since last quarter’s earnings season.  In early April the S&P 500 Index traded at a 19.5 P/E on a trailing basis and 18.75 on a forward basis according to Bloomberg estimates.  As of last week, those have increased to 21.56 and 20.8 respectively.  Noting that they rose by almost exactly the same amount, we can assert that the market’s gains were simply the result of investors’ willingness to pay more for the same amount of earnings, rather than earnings expectations outpacing that willingness.

We wrote at length yesterday about the clues that TSLA options were offering about market expectation for a post-earnings move.  The signals were mixed, with a roughly 7% move priced in and robust bids for calls.  The peak probability was assigned to a modest decline, but the lowest implied volatilities were in the $280 range.  Because of those contradictions, it is difficult to say whether options got it right or wrong.  As I write this, TSLA is down over 6%, so the broad volatility assessment was correct, but it also overshot the $280 level to the downside. 

Put simply, TSLA beat its EPS expectations ($0.91 vs $0.81 consensus) but disappointed on profit margins and guidance about them.  This was something we flagged as a risk yesterday:

Gross profit margins are considered to be a key metric.  They are projected to be about 18%, down from last quarter’s 19% and last year’s 30%.  As with any company, but even more crucially for TSLA, much of the market’s reaction will depend upon the company’s guidance, particularly about whether margins might rise sufficiently to allow profit upgrades.

The actual 18.2% margin didn’t seem too terrible, but it became more concerning when Elon Musk seemed peeved with repeated questions about margin expansion during his conference call.  He did his best to try to get investors focused on the future with talk about technology licensing and the cybertruck, but quite frankly one could easily assert that TSLA’s 85 P/E is pricing in a considerable amount of good news already.

In NFLX’s case, we saw a big EPS beat – $3.29 vs $2.90 expected – and a huge increase in subscribers, but the stock is down over 9% this morning, nonetheless.  But revenues were weaker than expected, and concerns about how the Hollywood strikes would weigh upon business came to the fore.

As for TSM, profits were above expectations too.  But it was its first quarterly drop since 2019 and the company’s guidance – including delaying its proposed plant in Arizona – was underwhelming at best.  The ADRs are down over 4% today as a result. 

The gravitational pull caused by significant declines in the 5^th and 14^th largest stocks in the NASDAQ 100 Index (NDX) has pushed that index down by over 1%.  But as I type this, the inertia in the S&P 500 (SPX) remains relatively intact.  SPX is only modestly lower right now.  Good results from Johnson & Johnson (JNJ), IBM and others are helping the less tech-heavy measure. 

It’s largely about perspective.  Over the past few weeks, the equity rally has broadened considerably.  Investors are now looking for value outside the “Magnificent Seven”, meaning that previously overlooked sectors can rally even on modest positives.  Consider the banks, particularly Goldman Sachs (GS).  The stock fell briefly tomorrow morning after reporting EPS of $3.08, well below the $3.92 consensus, but the stock is up about 4% since then. 

Perhaps the inertia is giving way to exhaustion – at least for the stocks that have benefited most from it.  In short, the better the recent performance, the higher the hurdle for future success.  Conversely, stocks that have been relatively languishing have a much lower bar for earnings success.  It is less about the actual EPS than whether investor expectations are appropriate.  Are we back to earnings whispers instead?