With US equity markets deep into Q3 corporate earnings season, today we have 3 points to keep in mind as you evaluate what these datapoints signal about the future direction of stocks:
#1: Always remember that the stock market looks 6 months into the future. A given stock might rise or fall after its earnings release, but that price action is related to expected future (not just-reported) earnings power.
To prove this point, the FactSet chart below shows Wall Street analysts’ estimates for 2022 (bottom line) and 2023 (top line) S&P 500 earnings per share. As noted, the S&P peaked on January 3rd of this year. Estimates, however, kept increasing until mid-June. They have been declining since. Markets anticipated that eventuality 6 months before it started to happen.
#2: Even though Wall Street analysts have finally started to cut their estimates in earnest, they are likely still too optimistic about 2023. Let’s take the same data as the chart above and look at how much the Street has reduced their forward year numbers already and how much further they may have to lower them:
Three points about the data presented in this chart:
- 2022 is almost over, so that $223/share number you see in the chart’s lower line is a reasonably accurate earnings power number for this year.
- With the Federal Reserve aggressively raising interest rates to cool the US labor market and economy, it is hard to believe that S&P earnings will rise 7 percent from 2022 to 2023. Economic recessions back to the 1980s have always caused earnings to decline by at least 20 percent. There are simply no historical exceptions to this rule.
- Even if we manage to avoid a recession, in our view the best-case scenario for 2023 S&P earnings is that they match this year’s $223/share.
#3: With the S&P 500 around 3,850 today, we can safely say that stocks do not discount any decline in corporate earnings 6-12 months from now. The math behind that statement:
- The S&P trades for 17.3x the $223/share earnings run rate we’ve seen in 2022.
- The index’s forward price-earnings ratio from 2014 – 2019 ran in a band of 14 – 19x. Investor confidence in future earnings determined where we traded at any given point on that continuum.
Since 17x is right in the middle of the historical PE band, we can safely say markets are reasonably confident S&P 500 earnings power will not decline in the next 2-4 quarters.
Investment takeaway: we believe the market is being too optimistic about S&P earnings power over the next 6-12 months, and we think investors should look at the large cap Energy and Health Care sectors as ways to hedge this valuation risk. Energy is the cheapest group in the index, at 9.3x forward earnings. Commodity prices should remain elevated, allowing this industry to earn its way into a higher multiple. Health Care valuations are in line with the S&P 500, but this industry is a classic defensive play for growth-oriented investors. Therefore, it should trade to a premium valuation as other sectors see their earnings power diminished in an economic contraction.
FactSet Earnings Insight report: https://advantage.factset.com/hubfs/Website/Resources%20Section/Research%20Desk/Earnings%20Insight/EarningsInsight_102122.pdf