There’s good news and bad news for earnings season. The good news is that the second quarter is likely to be the trough for earnings. The bad news is that earnings are not the problem, it’s valuations. They are very high, and that may prevent stock prices from moving forward even if earnings reports exceed estimates. The good news: Q2 is likely to be the trough Everyone knows that analysts tend to lower forecasts going into earnings season, and then companies top them by a small margin, usually 3%-6%. Analysts have indeed lowered estimates for the second quarter, but not by much. Many strategists, including Savita Subramanian at BofA Securities, expect the second quarter to be the trough for earnings, and analysts estimates agree. S & P 500 earnings by quarter (estimates) Q1: $54.83 Q2: $52.81 Q3: $55.76 Q4: $57.58 Source: Refinitiv The outlook for the rest of the year is not nearly as dire as it was 6 months ago. The earnings “apocalypse” — the collapse in earnings that many feared would be coming along with a serious recession in 2023 — has not materialized. So far, the soft landing scenario has been the correct scenario, one where inflation is slowly coming down, job growth moderates but still remains healthy, and corporate profits are stable and begin to slowly improve. The bad news: valuations The problem is that the market is very different now than six months ago. The S & P 500 is 15% higher than early January on the back of a big move up in technology, communication services, and consumer discretionary stocks, yet earnings expectations for 2023 are essentially the same. What this means is that the price of the S & P 500 has gone up to due multiple expansion, not because earnings estimates have been rising dramatically. S & P 500 P/E ratio, forward 4 quarters January: 17.2 Today: 19.2 The S & P is now trading at over 19 times earnings estimates for the following four quarters (Q3 and Q4 of 2023 and Q1 and Q2 of 2024). That is not only not a “recessionary” multiple, it is one that is usually associated with an expanding economy. It is also rarified territory. A P/E ratio of 19.2 ranks in the 84th percentile (since 1985) and a 9.2% premium to its 10-year average of 17.5, according to Refinitiv. Bottom line: The S & P 500 at 4,400 with forward earnings at $230 today (19.2 multiple) is not nearly as appealing as the S & P was in January, when it was at 3,800 with forward earnings at $220 (17.2 multiple). What’s it all mean? With higher stock prices, even good earnings may have trouble moving the markets The big move up in the S & P 500, Chris Harvey from Wells Fargo said, “suggests EPS results and guidance will need to be exceptional to get the market materially higher; a ‘sell the news’ reaction seems more appropriate.” Some companies are indeed exceeding expectations by a wide margin. Thursday morning Delta reported record revenue in the June quarter, with earnings of $2.68 well above expectations of a gain of $2.40. Full year guidance is also above expectations. That may be an exceptional report, however. Other early reporters that have reported more modest beats have had much more muted reactions, and many have even seen there second half estimates reduced. “If early 2Q 2023 reporters EPS estimate trends do not improve, the market either sells off or becomes extremely overvalued,” Nick Raich from the Earnings Scout said in a note to clients. Here’s why the market needs to broaden out Most of the reason the S & P 500’s multiple has expanded is because of the extraordinary gains of a small number of tech stocks (Apple, Microsoft, Nvidia) this year. At 27.2, the S & P technology sector forward P/E ratio is well above both it’s 5-and 10-year average: S & P Technology Index (Forward 12-month P/E ratio) Today: 27.2 5-yr. avg: 22.4 10-yr avg: 19.3 Source: FactSet/DataTrek By contrast, 8 of the remaining 10 S & P sectors have seen valuations that are either lower or only slightly higher than the average for the last five years. No wonder bulls are praying for the market to broaden out. It’s the easiest path to get the overall market higher. “While headline S & P 500 Q2 revenue and profit growth will likely prove uninspiring, at the sector level there are many groups performing reasonably well,” Nicholas Colas from DataTrek said in a recent note to clients. “This should encourage investors to look for opportunities outside of Big Tech and perhaps allow other groups to play catch up after lagging the overall market year to date.”
