Investors Are Optimistic About Earnings Season. Here’s What You Should Prepare For.

Second-quarter earnings season has kicked off, and you should be paying close attention. Stocks have been rallying this year, see, despite companies’ earnings dropping off. And that tells you one thing: if investors are willing to pay a higher price for lower earnings, it’s because they expect a strong recovery for the rest of this year and next. Let’s see how well-founded those expectations really are, and assess whether you should join the glass-half-full brigade or practice some self-restraint.

What’s the scene for the upcoming earnings season?

Investors have slashed their forecasts for the current earnings season, anticipating a roughly 8% overall fall from last year (check out the chart below). That’s mainly because profit margins are expected to shrink, especially in the energy and materials sectors. And for the first time in almost three years, firms across the board are predicted to post flatline sales versus last quarter, with energy and materials companies’ sales predicted to fall. Part of that’s because the sluggish economy has pulled down the volume of sales, but slowing inflation has also hindered the firms' ability to hike prices.

Estimates for second-quarter earnings have been falling significantly, making it less likely that they’ll disappoint. Source: Morgan Stanley

Mind you, energy and materials are expected to be the worst detractors of the lot, with falling commodity prices dragging on both their margins and sales growth. So if you exclude those pesky energy companies from the index, the S&P 500’s net profit margins are actually expected to increase by about 0.13%, with earnings falling only 3% versus the overall figure of 8%.

Energy and materials are expected to drag down earnings, while utilities and consumer discretionaries are expected to lead the pack. Source: Goldman Sachs

Looking further ahead, investors believe that non-energy companies’ earnings (gray dots in the chart) will continue to rebound from the lows seen at the end of last year. And they reckon this second-quarter point will mark a turnaround for the S&P 500’s overall earnings (blue bars) too. They’re expecting a strong recovery in the final quarter of this year with double-digit growth for non-energy companies, and predict that double-digit uptick to spread across the board next year as margins get healthier and sales turn more robust.

To uncover broader trends behind this potential pick-up, investors will likely scrutinize companies’ forward-focused guidance for information about three very influential themes. The first is artificial intelligence, with emphasis on the rate and profitability of the tech’s adoption. Second, credit conditions and the resulting impact on banks and credit-laden companies. And third, the state of consumer health, an indicator of the effect of interest rates and inflation on consumer spending.

Investors expect a strong rebound in earnings in the second half of the year, and double-digit growth in 2024. Source: Goldman Sachs

So what’s likely to happen?

Investors have already slashed their expectations by so much that realistically, earnings will struggle to disappoint this quarter. Instead, the most likely scenario is another batch of “not-as-bad-as-feared” earnings.

Thing is, unless earnings significantly beat their estimates, we’re unlikely to see the sort of rally that followed the previous earnings season. That’s because after the recent rally, the environment’s less supportive for any future ones. Valuations are already much higher, so there’s a far smaller margin of safety embedded in current prices. Positioning is already long and extended, meaning fewer investors will be left ready to buy. And now that the Federal Reserve (the Fed) is reducing its support for commercial banks, liquidity – essentially injections of money from the Fed – is less of a tailwind. Economic surprises have likely hit a peak, and there’s a high chance they’ll become more negative in the near future. Volatility is already extremely low, meaning investors have grown complacent and any surprises may worry them. And last but not least, the AI boom and its supportive power is diminishing. This all points to a limited upside, even if earnings deliver.

To me, though, it’s more important to focus on investors’ potentially overly optimistic outlook for the second half of this year and next year’s earnings. See, while a rise in valuation multiples – rather than a pick-up in earnings – has fueled the current rally, investors will need to see an actual improvement in earnings for prices to move decisively higher. That might be difficult. To reach the sort of double-digit growth investors are expecting, you’d need a significant stretch in margins and a strong pick-up in sales over the next few quarters. That’ll only be possible if inflation and interest rates both drop a notch, and if the economy recovers. And while that’s a possibility for sure, the downside risks are glaring. Stickier-than-expected inflation may prevent the Fed from easing its monetary policy, plus we may not have seen the brunt of the negative impact from the Fed’s previous aggressive rate hikes yet. Should an economic slowdown derail the earnings recovery, investors bull thesis may face a significant test and prices could reset lower.

So even though this particular earnings season is unlikely to revive the bearish sentiment, be wary of interpreting a decent season as a signal to go all-in on stocks. The bar for disappointment is set pretty low from here, so it’s still the time to proceed with caution. You know the drill: diversify your stocks across different regions, sectors, and styles, making sure to explore other asset classes like treasury bonds, gold, and maybe even bitcoin.