Over half the companies in the S&P 500 have reported their quarterly results by now, and it’s all panned out surprisingly well. Sure, they’ve been struggling with high inflation and rising interest rates, but there have also been a few reasons for investors to feel optimistic – hence the sudden rally in stocks. So let’s take a look at this earnings season’s good news, the caveats to keep in mind, and where this leaves stocks going forward…
Why are investors feeling so optimistic?
Revenue and profits grew across most sectors
The S&P 500 has seen overall revenue and profits climb 16% and 9% respectively from the same time the year before – a sign that companies have navigated a challenging environment pretty well. And while the energy sector – which benefited from higher energy prices – has been the biggest driver of those figures, it’s not alone: every sector’s revenue has grown, and 7 sectors’ profits have risen. Even if you exclude the strong performance of the energy sector, US companies’ revenue still rose by an inflation-adjusted 3.8%.
The results weren’t as bleak as expected
Investors generally focus less on raw numbers and more on how those numbers compare to what the market was expecting. The result for the second quarter so far is clear: companies have done better than analysts thought. In fact, you can see below that 52% of companies have significantly beaten estimates, while only 12% saw significant negative surprises.
S&P Q2 earnings results. Source: Goldman Sachs
Companies are still investing in growth
Companies’ capital expenditures (CAPEX) are generally a good way of gauging how worried companies are about the future. And according to Goldman Sachs, companies have on aggregate increased their CAPEX plans since the beginning of the earnings season. That suggests they’re confident that any stumble in growth is only temporary, and that better economic conditions will be back soon.
What’s the catch?
There are signs of trouble below the surface
If earnings updates have been beating expectations, it’s partly because analysts had already significantly lowered those expectations. And while most companies also significantly beat their own estimates, they do so almost every quarter: it’s common practice to underpromise and overdeliver. And there’s been a drop-off: 52% of companies on average have beaten estimates this earnings season, compared to 62% in the previous four quarters. Take another look at the chart above, and you can see that the results for this quarter are generally worse than the previous four. And those numbers aren’t even adjusted for inflation yet…
The economic environment might go from bad to worse
Inflation and rate hikes might’ve made for a tough economic environment in the second quarter, but things will probably only get tougher in the third and fourth quarters. That’s because it’ll take time for the Fed’s massive interest rate hikes to feed through the economy, in turn restricting and cooling economic activity. And if the economy shrinks, it’ll take a toll on corporate America: company profits have dropped by a median of 13% in past recessions.
Investors might be too bullish
Investors might have lowered their expectations, but they’re still optimistic: they’re anticipating profits will grow 6.7% in the third quarter, 6.7% in the fourth, and 8.9% in 2022 as a whole.
That’s even though “earnings revision breadth” – a net tally of the number of analyst estimate upgrades – has already started to dwindle. That’s not a good sign: a falling breadth (blue line) tends to indicate that the next 12 months of profit growth will fall (yellow line). If that pattern holds this year, there’s a chance companies will decide to flush out all their bad news at once in preparation for a better 2023. That could exacerbate the fall.
Falling earnings revision breadth often precedes falling EPS growth estimates. Source: Morgan Stanley
So where will stocks head next?
A deteriorating economic environment is going to make this performance difficult to keep up in the next two. And if profits come in much lower than expected at the next earnings updates, it stands to crush investor sentiment and send stocks lower. Put differently, the downside risks are bigger than the upside potential, particularly given investors’ optimistic expectations.
So if you came here looking for a sign to buy the dip, I’m sorry to disappoint you. But the fact is, you’ll either want to see prices and profit expectations drop to a level that truly reflects the risk of a prolonged downturn, or wait for evidence that companies can handle the worsening environment. We’re seeing neither of those things yet.
In the meantime, you’ll probably just want to hold a diversified, robust portfolio built to handle almost any environment, like this one. If it means missing some gains by being underweight stocks when markets rally, it’s no big deal: there are times to take risks, and times to remain cautious and limit your losses. Right now, it’s the latter.
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