Where Will Stocks Go After An Earnings Season Like This?

Where Will Stocks Go After An Earnings Season Like This?
Stéphane Renevier, CFA

over 1 year ago4 mins

  • Second-quarter earnings haven’t been as bad as they could have been: ever sector saw revenue growth, many companies beat their forecasts, and an overall increase in capital spending showed businesses don’t think the outlook is all doom and gloom.

  • But we’re out of the woods yet: a deteriorating economic environment will make it hard for companies to meet high expectations for the rest of the year.

  • The downside risks appear larger than the upside ones, so you might be wise to wait for a better entry level on stocks before buying the dip.

Second-quarter earnings haven’t been as bad as they could have been: ever sector saw revenue growth, many companies beat their forecasts, and an overall increase in capital spending showed businesses don’t think the outlook is all doom and gloom.

But we’re out of the woods yet: a deteriorating economic environment will make it hard for companies to meet high expectations for the rest of the year.

The downside risks appear larger than the upside ones, so you might be wise to wait for a better entry level on stocks before buying the dip.

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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. In fact, 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
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 really 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 even there, there’s been a drop-off: 52% of companies on average have beaten estimates this earnings season, compared 62% in the previous four quarters. In fact, 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 despite the fact that “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
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. 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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Disclaimer: These articles are provided for information purposes only. Occasionally, an opinion about whether to buy or sell a specific investment may be provided. The content is not intended to be a personal recommendation to buy or sell any financial instrument or product, or to adopt any investment strategy as it is not provided based on an assessment of your investing knowledge and experience, your financial situation or your investment objectives. The value of your investments, and the income derived from them, may go down as well as up. You may not get back all the money that you invest. The investments referred to in this article may not be suitable for all investors, and if in doubt, an investor should seek advice from a qualified investment advisor.

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