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How Earnings Can Guide Investors in Difficult Markets Thumbnail

How Earnings Can Guide Investors in Difficult Markets

With markets nervous about stubborn inflation, a gradually slowing labor market, and the timing of the first Fed rate cut, investors are more focused on this corporate earnings season than usual. While the economy has avoided a “hard landing,” corporate earnings only began to rebound in the second half of 2023. 

Since the stock market tends to follow earnings trajectory in the long run, many investors are hoping for signs that corporate profits will grow sustainably in the coming quarters. What do investors need to know today about how earnings might impact the stock market and economy?

 With 98% of S&P 500 companies having reported their first-quarter earnings results, the trends are positive. According to FactSet, 78% of large-cap companies had positive earnings-per-share surprises last quarter, which is better than the 10-year average. Blended earnings growth is clocking in around 5.9% year-over-year, the highest in almost two years, making this the third straight quarter of earnings growth.

According to LSEG data, the consensus estimate for S&P 500 earnings in 2024 is now $239 per share. If this is achieved, it would represent a 10.2% increase from last year. Wall Street analysts also expect continued growth of 14.0% and 11.7% in 2025 and 2026, respectively. The hope of an earnings rebound is one reason the stock market has rallied over the past year, driving up valuations.

In this environment, there are three key points long-term investors should keep in mind.

Earnings growth supports the stock market over time

First, while investors focus a great deal on topics such as inflation, the job market, and GDP, they do not directly invest in the economy. Issues such as the impact of higher interest rates, a slowdown in the labor market, or a “hard landing” affect investors through companies’ financial performance. In turn, this affects stock prices, which then impacts the overall market and investor portfolios.

The accompanying chart shows that while they do not mirror each other exactly, there is a strong relationship between corporate earnings and the stock market. The stock market tends to follow the earnings trajectory, with differences between the two lines resulting from changes in stock market valuations and investor sentiment.

This is why economic cycles matter for long-term investing: company sales tend to improve when the economy is growing and consumers are strong. Conversely, spending tends to slow during economic downturns, hurting corporate profits. Focusing on these longer-run trends is far more important for investors than trying to guess what the market might do in the short run. 

These dynamics can also impact how markets behave during pullbacks. If the market does experience a decline when the economy is otherwise strong, valuations will grow increasingly attractive. Eventually, investors will find it appropriate to add to their portfolios, helping to stabilize the market. 

In contrast, market pullbacks are much more challenging when they result from economic challenges such as recessions. This is why bear markets have typically only occurred after a significant recession or economic shock.

Earnings growth reached an inflection point last year

Second, as the accompanying chart shows, corporate profit growth reached an inflection point last year and has begun accelerating again after struggling in 2022. 

While the economy avoided a recession that year, the stock market entered a bear market partly because of an “earnings recession” among large-cap companies. While the historical average earnings growth rate has been 7.6% since the mid-1980s, earnings growth tends to fluctuate in cycles tied to the business cycle and shorter-term industry trends.

Earnings growth rates also affect whether the stock market appears “cheap” or “expensive.” The price-to-earnings ratio, for instance, is simply the price of a stock or index divided by some earnings measure, such as expected earnings over the next twelve months. This means that even if prices don’t change, increasing earnings will make the market more attractive, and vice versa.

Of course, stock market prices have risen significantly over the past 18 months. The current S&P 500 price-to-earnings ratio is just under 20 times next twelve-month earnings, partly due to the strong bull market rally pushing up the numerator and partly because earnings growth only supports the denominator. If earnings growth continues to accelerate, valuation measures such as the price-to-earnings ratio could improve.

Economic fundamentals remain strong

Third, concerns over a recession or “hard landing” have moderated in recent quarters. According to FactSet, the term “recession” appeared in only 100 transcripts of earning calls of S&P 500 companies compared to 302 a year ago. 

This is the fewest mentions in two years and mirrors the improving sentiment across financial markets. Fed funds futures, for instance, are now anticipating mild rate cuts this year compared to the start of this year when many investors expected the Fed to cut rates rapidly in response to a possible recession.

Additionally, data from the Federal Reserve Bank of Richmond’s CFO Survey echoes this sentiment – optimism about the economy reached its highest level since the second quarter of 2021. Estimates by Chief Financial Officers for real GDP growth for the next year average 2.2%, up from 1.7% at the end of 2023. 

Only 10.1% of CFOs believe a recession will occur over the next year. While these projections are not always correct and are subject to change, they provide additional insight into how corporate executives view the current economic climate.

The bottom line: The latest earnings figures show that companies are performing well, which is a positive sign in this uncertain market environment. In the long run, investors should focus more on trends around economic fundamentals such as earnings than on day-to-day stock moves.

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Matt Faubion, CFP®

Founder - Wealth Manager

This article is for informational purposes only and is not a replacement for real-life advice, so make sure to consult your tax, legal, accounting, and financial professionals if you want more information. This content is developed from sources believed to be providing accurate information, and provided by Copyright (c) 2024 Faubion Wealth Management LLC, and Clearnomics, Inc. All rights reserved. It may not be used for the purpose of avoiding any federal tax penalties. Please consult legal or tax professionals for specific information regarding your individual situation. The opinions expressed and material provided are for general information, and should not be considered a solicitation for the purchase or sale of any security.