Most of earnings season will take place over the next 3 weeks
Q2 earnings season got off to a decent start over the last week.
Continued consumer demand was a trend, with a few big banks seeing credit card borrowing offsetting increased deposit costs and lower investment banking activity, while travel demand drove record earnings for Delta, and resilient consumers helped Pepsi beat expectations.
The next 3 weeks will see most of the companies in the S&P 500 reporting (chart below), which will give markets more information – in addition to macro data – about costs and sales and sectors seeing growth (or not).
Q2 expected to be low point for earnings, marking end of “earnings recession”
Analysts are expecting to see a continuation of the “earnings recession” that’s been underway since Q4 2022 (chart below), with estimates calling for negative 7.5% YoY earnings growth (orange bar), which would be the worst quarter since Q2 2020.
Looking at the data, most of the weakness is coming from Energy (with oil prices falling 35% YoY in Q2) and Materials (due to weaker goods demand). Excluding Energy and Materials, Q2 S&P 500 earnings are actually estimated to increase 0.8% YoY.
More importantly (for valuations), Q2 is expected to mark the low point for earnings, with forecasts saying earnings should turn positive by the end of the year (green bars).
Earnings weakness due to higher costs and fading pricing power compressing margins
The reason earnings has been negative in recent quarters is because costs have been rising (thanks to inflation) more than revenues.
- The black line below shows sales have been climbing steadily for 2+ years. As we’ve seen, consumer spending has remained resilient, despite the Fed’s rate hike cycle. That seems to show that even though inventory is now recovered, discounting is not happening.
- However, the blue line still shows earnings (profits) falling from last July into the early part of this year. That would indicate high wage growth and other rising costs have hurt company margins.
Q2 earnings revisions return to normal trajectory after three worse-than-normal quarters
Although this is expected to be the worst year-on-year quarter for earnings, other data show it’s not so bad.
Research from Deutsche Bank (chart below) shows:
- Earnings are typically revised down as you closer to the actual earnings date, only to rebound after companies beat estimates, typically around 70% of the time (green line).
- In the past three quarters, those revisions have been worse than normal (light blue, purple and orange lines). That’s partly due to expected headwinds from rate hikes, recession risks, margin compression and rising costs.
- However, this quarter is back to tracking the longer-term average (dark blue line). In short, negative revisions are not as large as we have recently seen ahead of actual earnings.
It may have helped that Q1 earnings came in much better than expected, boosting confidence about the economy’s resilience. If that happens again, then that negative 7.5% YoY growth forecast could also get a lot less negative.
Earnings will drive valuations too
What does this all mean for valuations?
In the chart below, we can see that stock valuations (seen in prices/earnings ratio) are driven by a combination of earnings (the E in the Price/Earnings ratio, on the vertical axis) and interest rates (the horizontal axis).
Where we are now is the big orange dot, while the long-term trend line is a rough guide to “fair value.” That would indicate stocks are a little (15%) above trend valuations. However, stocks price in the future values of companies, while this chart is using current data.
If rates fall or earnings rise the orange dot would move back closer to the trend. Currently, markets are:
- Forecasting an earnings recovery of around 10% in 2024 (green bars in chart above)
- Pricing in the Fed cutting short-term rates to around 4% (from their current 5.25%) by the end of 2024, which may pull 10-year yields down.
So although the market rally seems to be getting ahead of the economic data, it’s possible the market is looking forward to a soft-ish landing for the economy with interest rates able to fall back down a little.
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