What earnings season means for valuations, clients

Q3 earnings season is underway and while it’s still early, we are beginning to see forward guidance that points to profit growth looking forward. Key reports from US financials lay out how rate increases are being felt throughout that industry, and might perhaps give some investors reason for hope in what has been an uncertain year for equity markets.

Josh Sheluk, however, is advising caution. The portfolio manager at Verecan Capital Management emphasized that as many headlines as earnings season can eat up, short-term performance in equities is likely to be driven by valuations. He explained, in that context, how advisors might want to view both US and Canadian financials, as well as how they might talk down clients who want to go all in on one strong earnings report.

“Valuations are always going to drive the bus more than earnings will in terms of the actual price of stocks,” Sheluk says. “Earnings will play less of a role in what we’re experiencing on a short-term market fluctuation basis. You could very well have a scenario where we see multiples contract big time in a recession, and earnings could continue to be okay.”

Within that context he notes that some earnings reports so far in Q3 can highlight the long-term health of key sectors. Notably, financials which had struggled during the spring financial crisis with deposit costs skyrocketing due to high rates. Sheluk now sees momentum in many US banks as net interest income exceeds those higher deposit costs.

Given the compressed valuations for many US banks from earlier in the year, Sheluk sees an opportunity to capture well priced companies with better growth trajectories. He notes, however, that it’s important to be selective with US financials. He prefers large national institutions to some of the smaller regional banks that remain plagued with risk.

While Canadian financials are now enjoying the same tailwinds of interest income, they have a few Canada-specific factors making them less attractive. Notably, valuations on Canadian banks remain high and Canadian household debt levels are significantly higher than in the US. Both of those factors could weigh on Canadian financials’ performance in the long term.

Sheluk noted that forward guidance from earnings reports so far has been revised upward, for the first time in several quarters. He caveats that slight optimism with an inflation adjustment, which might bring earnings expectations back into negative territory. That uptick on earnings, he says, may not answer the recession question that seems to be moving markets these days. There could very well be an improvement in corporate earnings overall, but if markets see labour figures drop and clearer signs of a recession ahead, equities could very well still fall significantly.

The wider macro story is going to be crucial for advisors as they talk to clients about earnings season, Sheluk says. Because equity valuations will continue to be driven by inflation prints and central bank guidance, rather than individual earnings, he believes that context remains a key area to reiterate with clients. If valuations drop but earnings look strong, that could present opportunities to pick up long-term holds. However, in an era of the hyper-informed client reiterating context is a crucial step every advisor has to take. When clients send emails about earnings season, asking for purchase orders on impressive reports, Sheluk and his team work on outlining context and questions that can steer their clients’ thinking towards the long-term.

“We ask follow-up questions to whoever brings us that datapoint,” Sheluk says. “If somebody says ‘this company had a great earnings release, we should buy it,’ we ask them what one great earnings release has meant in the past for that company. When something more superficial, like a single news report, occurs for a company then asking these follow up questions can help a client make a much more informed decision.”