Earnings to dictate the market’s next move

The third-quarter earnings season will begin in earnest towards the end of next week with several important US banks reporting. The focus will be, more than ever, on how much of the economic weakness is feeding into companies’ earnings and how comfortable management will be in elaborating on their guidance.

Looking ahead, the estimated earnings growth rate for S&P 500 earnings in this year’s third quarter is 2.9%, which, if confirmed, would mark the lowest earnings growth rate reported by the index since Q3 2020. The trajectory for earnings estimates for the remaining two quarters of this year and the first two quarters of 2023 has been revised decidedly lower throughout the course of the year. Estimates for the third quarter have fallen from more than 11% at their peak in June, while fourth-quarter estimates have been cut more than half from their peak at the start of the year. 

One of the clear themes throughout the bear market we have had so far this year has been the significant reduction in valuation multiples; namely, those based on forward and trailing earnings. The widely followed forward price-to-earnings (P/E) for the S&P 500 collapsed from 22.9 times at the beginning of the year to just below 18 times at the moment—a drop of almost 22%.  

Most of that re-rating was driven by large-cap growth equities, given that they were trading at hefty multiples at the turn of the year. As inflation heated up and expectations of more aggressive rate hikes by the Federal Reserve kicked in, longer-duration/higher-multiple equities were hit due to the higher discount rate used to value future earnings.

At this stage of the cycle, lower valuations multiples do not necessary imply that equities are trading cheaply. That’s because forward earnings growth has not yet contributed to the market’s drawdown in a significant way this year. In other words, earnings in the forward P/E metric have increased while the P/E itself has declined. Thus, there currently remains a risk that analysts and companies may guide down and reduce their estimates for the months ahead, in which case, the correction may have further to go.

While valuation analysis remains a useful tool for assessing the market’s attractiveness, history shows that in reality, very much will depend on where investors place greater importance. Investors who like to compare the equity market’s yield to that of the bond market will likely not hesitate in saying that equities remain attractive today. And yet, investors who take issue with the rapid growth in multiples relative to the growth in the economy may be less comfortable with the state of the market today.

Regardless of one’s view, the indisputable reality today is that the Fed remains engaged in one of the most aggressive rate-hiking cycles in history. Confirmed by what we have seen this year, this has historically weighed on valuations. On top of that, growth stocks represent a much larger portion of the market today compared to the last era, with inflation running above 8%. If higher interest rates continue to dent those equity valuations and earnings growth slows, there is less upside for profit margins.

Disclaimer: This article is brought to you by Stephen Borg, Head of Private Clients at Calamatta Cuschieri. The article is issued by Calamatta Cuschieri Investment Services Ltd, which is licensed to conduct investment services business under the Investments Services Act by the MFSA and is also registered as a Tied Insurance Intermediary under the Insurance Distribution Act 2018.

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