Earnings season has arrived, and for many investors and traders, these periods of the year are akin to “March madness” for basketball fans.

Corporate earnings and stocks are intimately linked because the price of a stock is often founded on earnings expectations/projections for a given company. Therefore, when a company announces its quarterly earnings and ongoing financial projections, prices in the market often fluctuate—sometimes significantly.

Earnings have been particularly interesting during the COVID-19 pandemic because this information has allowed market participants to gauge the relative impact of the pandemic on the vast array of market sectors and companies within them.

Last year, the big question was how earnings might be impaired by the pandemic. But in 2021, most market participants are watching for clues into the nature of the post-pandemic rebound.

For example, will strength in the technology sector sustain itself in 2021, relative to 2020? Will some of the losing sectors from 2020 regain their footing in 2021? Q1 earnings reports—as well as Q2 earnings reports later this summer—should provide answers to such questions.

Overall, earnings reports for Q1 2021 are expected to be strong, as evidenced by the expectation for total S&P 500 earnings to increase +19.8% in Q1 as compared to the same period last year. Revenues are expected to be about +5% higher.

One complicating factor is that earnings gains versus 2020 aren’t necessarily that helpful when it comes to ascertaining a given company’s true growth prospects. To derive that information, it may be necessary for savvy investors and traders to compare the 2021 data with 2019 data, before the onset of the pandemic.

Using this approach, it becomes clear that some sectors of the market are poised to make real gains in 2021. For example, 2021 earnings growth in the tech sector is expected to be 27% higher than the levels observed in Q1 2019—undoubtedly indicating robust growth.

On the other hand, Q1 earnings in the financial sector are expected to be -1.3% below their 2019 Q1 level. Information such as this helps illustrate why the tech-heavy Nasdaq was such an outperformer last year.

The chart below demonstrates how earnings growth for the entirety of 2021 is expected to rebound 24% as compared to 2020. But the chart also reveals that corporate earnings growth in the United States had started to slide before the pandemic started—with 2019 earnings growth anemic as compared to 2018.

While the above chart does provide projections for earnings growth beyond this year, those might be taken with a grain of salt, given the unpredictable nature of the ongoing pandemic.

Moving on, another important metric that investors and traders can use to monitor corporate earnings health and associated valuations in the stock market is the S&P 500 Price/Earnings (P/E) Ratio.

The P/E Ratio is calculated by taking the average stock price of large-cap stocks in the S&P 500 Index and dividing that collective price by the respective mean earnings of those companies. The quotient of that calculation typically equates to what many refer to as the P/E of the “market.”

This figure is important because it can be tracked over time, and since the early 1900s, the average P/E for the market has hovered right around 17.

When the market’s P/E rises above 17—especially to an extreme degree—some market pundits start to worry about “overvaluations.” The same can be said when the market’s P/E drops below 17, although in that case the concern is that stocks might be getting undervalued.

For reference, the P/E Ratio of the S&P 500 (aka “CAPE”) rose above 40 a few months before the 2001-2002 “Tech bubble” corrected. Currently, the P/E Ratio for the S&P 500 is about 42, which for some has set off alarm bells.

Lofty valuations in the market have gathered quite a bit of attention lately, with the CEO of Tesla (TSLA), Elon Musk, even chiming in on the topic:

Despite concerns such as this, one can’t forget that the impairment of earnings during the pandemic is an important reason why the ratio might be so high at this time. With earnings down, that means the denominator of the P/E equation is lower—ultimately pushing the quotient higher.

In other words, the market may be allowing the P/E Ratio to range well above its historical average because investors and traders expect corporate earnings to “catch up” in the near future, and slowly push that P/E back toward its historical mean.

Based on current earnings projections, that certainly appears to be a likely (although by no means guaranteed) scenario.

If an “earnings recovery” doesn’t materialize as expected, then the current P/E Ratio of the S&P 500 might have to be cut down by other means—namely a drop in prices.

This topic also helps explain why the market seems averse to plans by the current White House administration to raise corporate taxes. Higher taxes generally equate to lower earnings, an unfortunate reality that could ultimately drive stock market prices lower, too.

To learn more about trading strategies geared toward corporate earnings season, readers may want to review a recent episode of Tasty Bites on the tastytrade financial network.

Sage Anderson is a pseudonym. He’s an experienced trader of equity derivatives and has managed volatility-based portfolios as a former prop trading firm employee. He’s not an employee of Luckbox, tastytrade or any affiliated companies. Readers can direct questions about this blog or other trading-related subjects, to support@luckboxmagazine.com.