Market Pulse - 2 August 2023

What Flat Earnings Amid a Healthy Economy Mean for Investors

Recent economic figures, which show improving inflation and steady GDP growth, continue to support the market rally. The S&P 500 has gained over 20% with dividends this year and is now only 4.5% below its early 2022 peak. The Nasdaq Composite and the Dow Jones Industrial Average have returned 37% and 8%, respectively. These are sharp reversals of last year's market trends and serve as a reminder that conditions do not need to be perfect for markets to turn around if conditions are moving in the right direction. At the same time, investors should always be prepared for periods of uncertainty. What long-term trends should investors be aware of today?

The recent GDP report for the second quarter showed that, adjusted for inflation, the U.S. economy grew at a healthy pace of 2.4% quarter-over-quarter. Not only was this better than many economists expected, but it represents an acceleration from last quarter's 2.0% growth rate. Despite experiencing two consecutive quarters of negative growth a year ago and the many recession forecasts at the start of the year, the economy is growing steadily. Among many factors, this is due to robust consumer spending and a rebound in business spending as households and corporations adjust to the inflation shocks of the past two years, as shown in the accompanying chart that breaks down the components of GDP.

However, these improvements have not yet appeared in corporate profits. The corporate earnings season for the second quarter is halfway through and about 80% of S&P 500 companies are reporting positive earnings surprises while 64% have positive revenue surprises, all according to FactSet. However, this is due to very low expectations among Wall Street analysts. All told, blended earnings growth for the S&P 500 likely declined in the second quarter, making for the third straight quarter of falling profits.

For the full year, 2023 will likely experience flat earnings growth. According to Refinitiv, the current consensus earnings-per-share estimate for 2023 is just under $214, compared to $215 last year. If this occurs, it will be disappointing given the 7.8% average earnings growth rates over the past four decades. Despite these challenges, there are two important facts to keep in mind.

First, these same forecasts also anticipate an earnings recovery, possibly beginning in the fourth quarter. So, while growth in 2023 may be flat, growth over the next twelve months is expected to be a healthy 8%. Analysts also expect 2024 and 2025 to each generate 12% earnings growth. Although these numbers will likely come down, as they often do, this would be a healthy rebound after this year's earnings pause. Given the choppy economic environment over the past year and the rapidly changing conditions today, what happens over the next year should drive markets more than what's already in the rearview mirror.

Earnings growth has stalled in 2023

Second, it's not unusual for corporations to experience temporary profitability slumps. Recent earnings downturns occurred during the pandemic recession, in 2019 during a period of slowing growth, in 2015 and 2016 when oil prices collapsed, and many other periods. Today, this is due to the ongoing recovery in inflation and the various factors that are impacting each sector.Tech, for instance, has experienced sizable layoffs but also high demand for artificial intelligence-related hardware and tools. Financials are stabilizing after the banking crisis earlier this year and many of the largest diversified banks have benefited. Energy sector profits surged last year as oil prices jumped but this has turned around. All in all, eight of the eleven S&P 500 sectors are expected to experience positive earnings growth in the coming year.

One reason for long-term investors to focus on corporate profitability is that earnings growth is a fundamental component of stock returns. By buying a company's stock, investors have the right to share in profits. The value of this right to shareholders depends on the growth in the company's earnings along with market valuations. Over the long run, steady earnings growth is what drives stock prices higher. In turn, earnings depend on economic growth and controlling costs, which is why trends among consumers, businesses, and inflation are so closely followed by long-term investors.

Companies in the S&P 500 are trading at about 19.7 times their projected earnings over the next 12 months, according to FactSet, up from a multiple of roughly 17 at the beginning of the year and above the five-year average of 18.6.

By another measure of valuation, stocks haven’t looked this expensive in more than a year. The S&P 500’s cyclically adjusted price/earnings ratio, or CAPE, which compares the index’s price relative to inflation-adjusted corporate earnings over the past 10 years, stood at 30.8 as of early July, the highest since April 2022.

Some investors anticipate earnings expectations to fall further as a potential recession looms and the Fed’s rate increases make their way to companies’ bottom lines.

So far this earnings season, companies are beating Wall Street projections at a greater rate than usual. With results in from about half of the companies in the S&P 500, 80% are topping analyst expectations, compared with the five-year average of 77%, according to FactSet.

Stocks Shrug off Recession Signals

Inflation has cooled and the economy keeps motoring along. The jobs market remains robust, with the unemployment rate hitting a 53-year low earlier this year before ticking up just slightly. Americans have been spending more at retail businesses. Economists are raising estimates for gross domestic product in the second and third quarters.

“There’s an actual chance here the Fed could stick the landing,” said Dryden Pence, chief investment officer at Pence Capital Management.

Still, there are reasons for concern. The Conference Board said last week that its leading economic index fell for a 15th consecutive month, signaling slowing economic activity ahead. That is the index’s longest streak of declines since a span from the spring of 2007 through early 2009. The U.S. economy fell into a recession in December 2007 and didn’t exit until June 2009.

The bond market is flashing another warning sign. Normally, longer-term U.S. Treasurys carry higher yields than shorter-term ones, paying investors for the risk that interest rates rise or inflation accelerates. When the longer-term yields are lower, it often suggests that investors think the Fed will need to cut rates to resuscitate the economy.

The yield on the benchmark 10-year U.S. Treasury note has been lower than that of the 2-year Treasury for more than a year, the longest streak since a span ending in 1980, according to Dow Jones Market Data.  

There have also been glimpses of weakening in the market for bank loans. Loan officers at U.S. banks told the Federal Reserve earlier this year that they had tightened lending standards for households and businesses and seen lower demand from borrowers. Tighter lending conditions can weigh on economic growth as firms pull back on investment and hiring and consumers have less money at their disposal.


Earnings are projected to be flat this year but the economy is growing steadily, inflation is improving, and most sectors are expected to rebound. In the long run, earnings growth is the most important driver of stock market returns which in turn help investors achieve their financial goals. That being said, investors should be cautious when putting new capital to work and chasing or over-allocating portfolios into hot themes such as AI. There is always a place in portfolios for tactical allocations such as AI, but investors should be disciplined and take relatively small positions in tactical themes.

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