S&P 500 companies’ earnings growth will now remain on the radar of investors and analysts. From near-zero interest rates almost a year back, the US economy is facing tough times with interest rate levels of around 3%, after September’s third consecutive rate hike of 75 bps. The US stock market is in the bear market territory and the valuations may come down further for many stocks as the outlook for the market remains gloomy. A big reversal for the market may not happen unless earnings growth is visible in the US economy.
According to a Charles Schwab recent analysis note, S&P 500 earnings were up more than 8% in the second quarter, but excluding the Energy sector, they were down more than 2%. In a few weeks, the third-quarter earnings season begins, with much hand-wringing about whether this will be the season when economic weakness translates to earnings weakness.
As per the note, the weakness in expected earnings growth is early in its trip to an ultimate negative (year-over-year decline) destination. FedEx news of an expected earnings implosion and the company’s removal of all forward-looking guidance is a likely canary.
Stocks of companies beating estimates were rewarded on the day of their earnings release, but at a lower rate than the prior two quarters. Conversely, stocks of companies missing estimates were punished to a more significant degree than anything seen over the past five years.
Earnings Estimates Outlook
Looking ahead, the estimated earnings growth rate for S&P 500 earnings in this year’s third quarter is 5%; if the Energy sector is excluded, it’s expected to be down nearly 2%.
The trajectory for earnings estimates for the remaining two quarters of this year and the first two quarters of next year has been decidedly down since earlier in the year.
Estimates for the third quarter have fallen from more than 11% at their peak in June, while fourth-quarter estimates have been cut by more than half from their peak at the start of the year.
For the first half of next year, estimates are also well below where they were earlier this year; although they did pick up in August before leveling out again.
Earnings growth is a significant factor supporting stock values. One could assume that great stock market performance would follow high earnings growth rates, but earnings are reported after the fact, and stocks are a discounting mechanism. As of the fourth quarter of last year, earnings growth was over 32% at the start of this year, but the bear market plunge started just three days later.
So, what could be the earnings growth levels that need to be watched closely?
Earnings growth of more than 20% has historically been accompanied by a barely positive annualized return of less than 2%; the best zone for stocks has historically been when earnings growth is between -20% and +5%.
Perhaps no surprise is that the worst earnings zone for stocks is when earnings were imploding (worse than -20%). But what the trajectory of the data shows is that once earnings bottom and begin to accelerate, that’s when the strongest market gains kicked in.