As U.S. stocks scale fresh record highs, investors are trying to gauge whether next year's projected profit rebound will be strong enough to add fuel to the rally.
Analysts are projecting that earnings for S&P 500 companies will rise 23% next year after falling more than 15% this year due to the coronavirus pandemic, according to IBES data from Refinitiv.
Yet stock prices have already staged a massive recovery from the March lows of the pandemic, with the S&P 500 index rising more than 60% from its bottom to its recent record highs amid progress toward a COVID-19 vaccine and hopes for a speedy economic recovery.
The S&P 500 is trading at 23 times expected earnings for the next four quarters, only slightly lower than its June peak of 25 times expected earnings - its highest in roughly two decades. Those multiples are well above the long-term average of about 15, based on Refinitiv's data. The sharp run-up in U.S. shares since March against a backdrop of still-weak earnings has driven up valuations.
Indeed, U.S. stocks have climbed despite another surge in virus cases across the country as well as a slight deterioration in profit projections for next year. S&P 500 earnings growth estimates for 2021 have weakened from 28% on Oct. 1 to 22.5% as of Friday, based on Refinitiv's data.
"A disconnect is starting to occur," said Nick Raich, chief executive of The Earnings Scout, an independent research firm.
"So one of two things have to happen. Either estimates have to catch up with price, or price will have to come down if we don't see a compensatory rise in earnings expectations."
Longer lockdowns because of the virus are among the reasons the near-term risk for stocks is "skewed to the downside," Savita Subramanian, head of U.S. equity and quantitative strategy and global head of ESG research for BofA Global Research, wrote in her 2021 outlook report last week.
Some strategists argue that consensus estimates for next year underestimate the rebound that is likely to take place in earnings.
"There was a great sense of just surviving," said Jim Paulsen, chief investment strategist at The Leuthold Group in Minneapolis, resulting in corporations cutting operations "down to the nubs."
"If you bring back growth, we'll have more of that fall to the bottom line than ever before," he said.
With results in from 97% of companies, the S&P 500 looks set to post just a 6.5% decline in third-quarter earnings, a vast improvement over the 21% fall that had been projected on Oct. 1, based on Refinitiv's data. Fourth-quarter earnings are projected to decline 11%, versus the 13.6% drop forecast on Oct. 1.
Still, a lot depends on the timing of the rollout of a COVID-19 vaccine, analysts said, since that will determine how fast normal business activity can resume.
The most economically-sensitive sectors are expected to see the biggest year-over-year profit growth in 2021. Analysts expect energy earnings to jump nearly 600% in 2021, while they project industrial earnings to climb 79%, based on Refinitiv's data.
Investors are also waiting to see if President-elect Joe Biden's policies will be market-friendly. Biden has floated the possibility of tax hikes, which could restrain earnings growth.
In a Reuters poll published on Wednesday, most strategists said they see earnings returning to pre-pandemic levels within a year, but some said earnings could take longer to rebound if taxes rise.
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