It's easy to forget given other noise, but earnings still matter

These days in financial news, politics grab all the headlines, the Fed gets all the credit and coronavirus takes all the blame. With those three subjects dominating the media, nobody seems to have much interest in earnings.

In a time when impeachment trials and GameStop stock-pumping scratch the itch for drama, a conversation about corporate earnings is more like watching the weather forecast; it need not be exciting to have a real impact. Earnings will likely determine whether or not the stock market remains hot in the months ahead.

In more normal economic conditions, that statement would elicit little more than a shoulder shrug. Earnings forecasts and relative results are historically among the biggest drivers of equity prices. By contrast, many of the best-performing stocks in 2020 had more to do with popularity than with profits.

Earnings still matter, but the feedback loop between a company's share-price and its quarterly results seems to be operating in reverse. Think of it this way: Strong earnings traditionally are the rising tide that lift stock prices higher. In 2021, however, the market is bathing in Fed-driven liquidity with the hope that strong earnings will justify each high water mark we have already reached.

The risk, of course, is that weaker-than-expected earnings quickly drain the momentum from this rally. Fortunately, that seems unlikely in the immediate future. As we near the end of fourth-quarter earnings season, S&P 500 companies grew earnings at a blended rate of 3% compared to a year earlier. That number blows away consensus expectations as of Dec. 31 that S&P earnings cumulatively would decline 9.3%.

The bar will be even lower for each of the next two cycles. Earnings numbers to be reported in April and May will be compared to Q1 2020, which included the first round of pandemic-induced economic shutdowns. Earnings reported this July and August should look even better on a year-over-year basis for similar reasons.

The favorable setup for earnings could help pave another six months of relatively smooth runway for stocks, even though U.S. equities carry lofty valuations using traditional methods. The S&P 500 trades around 22 times forward earnings estimates. The cyclically adjusted price-to-earnings ratio (also known as "CAPE" and "Shiller P/E") has reached a level only seen twice before, in 1929 and in 1998.

The bigger challenge will come this fall. U.S. economic growth will almost certainly accelerate in the second half of 2021 as America moves toward herd immunity, we inch closer to normal life and pent-up demand contributes to a consumer spending boom. Those are all positive developments, but the market — especially this market — does not always move in lockstep with underlying economic trends.

Third-quarter earnings will have a much higher bar to exceed and by then the convenient COVID-related reasons used to excuse slower growth may be gone. Later or sooner, earnings will again be what matter most.