Checking in on Earnings Season

With the banks kicking off the first quarter 2023 earnings season on Friday, it feels like an appropriate time to revisit the earnings outlook for the broader market. According to Factset, earnings for the S&P 500 are expected to decline by 6.6% in 1Q23. This would represent the steepest year-over-year drop in earnings for the index since the early days of the pandemic when EPS fell by more than 30% in the second quarter of 2020. Moreover, this would be the second consecutive quarter that S&P 500 earnings have declined, setting up the potential for an official earnings recession. Broadly speaking, company margins are under pressure from weaker consumer demand, lower pricing power, and a decline in productivity.

This outlook has led to continued downward revisions for both 2023 and 2024 earnings estimates. From the respective peaks, S&P 500 2023 and 2024 earnings estimates provided by Factset have declined by 12.3% and 10.7%. On a year-over-year basis, 2023 earnings are now expected to grow by just 1.5%, which compares to an expected 6% increase at the start of the year. In addition to the pressures mentioned above, these downward revisions can be attributed to the tighter credit conditions brought on by the Fed’s actions to fight inflation.

In previous market commentaries, we expressed concerns that 2023 earnings growth would largely depend on economically sensitive areas of the market. As illustrated in the chart below, this remains true today, with the Consumer Discretionary, Communication Services, Industrials, and Financials sectors projected to see the strongest growth in 2023. Simply put, these sectors are more closely tied to the broader economy, and thus are more susceptible to downward revisions during macroeconomic downturns. There is evidence that this has already started to materialize; since the start of the year, earnings estimates for the Consumer Discretionary and Financials sectors have declined by 8.6% and 6.9%, respectively

Despite the uncertain outlook, stocks have continued to climb the wall of worry with the index rising 7.5% year-to-date. While higher stock prices are typically welcome news for investors, we highlighted in the recent edition of the Farr View that there has been a notable lack of breadth in the year-to-date rally with only a handful of stocks responsible for the positive returns in the market. The combination of higher stock prices and lower earnings estimates has led to a richer valuation for the index. With a forward P/E of ~18x, the S&P 500 currently trades above its 10- and 20-year averages of 17.5x and 15.7x.

As always, we find it useful to consider a wide range of outcomes to get a sense of the risk/reward trade-off for the market. In the matrix below, we show the potential year-end 2023 S&P 500 index level and corresponding returns compared to the current value of 4,109 (as of the close of 4/11/23). The range of earnings estimates in the matrix represents a plus or minus 10% and 20% move relative to the current consensus earnings estimate of $219.

The key question heading into the 1Q23 earnings season is whether earnings estimates have come down far enough. Investors will closely monitor how management teams are dealing with the weaker consumer demand environment, tighter credit conditions, and the subsequent impact on margins. If the economy slips into a recession, as many pundits have predicted, history tells us that earnings typically decline by more than 20%^[1]. The bears will argue that this outlook is far from priced in and thus the market will have to adjust to reflect the lower earnings outlook, while the bulls will counter that there are plenty of mixed signals and a recession is far from a certainty. Meanwhile, we will stick with our discipline of investing in high-quality companies with experienced management teams that can generate solid risk-adjusted returns for shareholders across a full market cycle. Be careful out there!

[1] Source: LPL Research. April 12, 2023.