Sifting Through the Data

The second-quarter earnings season has been a positive one so far.  Of the 230 companies in the S&P 500 that have reported, roughly 83% exceeded their consensus EPS estimate and 67% exceeded their consensus revenue estimate.  The average upside EPS surprise has been about 6%, while the average upside revenue surprise has been about 2%.  This is obviously good news.  But we all know that most corporate management teams engage in a practice known as “sandbagging”, which simply means that they provide guidance that can be easily exceeded.  In any case, the generally positive earnings reports so far provide some validation for the strong rebound in stock prices since the correction earlier in the year.

That said, the future direction for stock prices will not be determined by what’s in the rear-view mirror but rather what happens in the future.  Fortunately, things are looking a bit better here as well.  It appears as though earnings estimates have finally stopped dropping.  The chart below shows the history of earnings estimates since the end of 2023.  It’s clear to see that estimates had been dropping since mid-2024 until we finally saw an upward inflection in just the past couple of months.

Why is the upward inflection in earnings estimates so important?  Because stock prices are already baking in upward earnings revisions.  The chart below shows that the price-to-earnings ratio (using the consensus estimates over the next twelve months) on the S&P 500 has yet again climbed to historically high levels.  In fact, the current ratio, at 22.5x has not been as high since the bursting of the dot-com bubble in 2000 (if we exclude the artificially high ratios following COVID’s arrival).  In other words, stocks generally don’t trade at such high valuations unless investors expect the earnings outlook to improve.  

Next, I wanted to touch on the second-quarter GDP data that was released on Wednesday.  Headline GDP growth came in at 3.0% for the quarter, handily ahead of the consensus expectation of 2.6%.  But, as is often the case, the beat relative to expectations wasn’t so encouraging if we dig a little deeper.  The categories that most impacted the 3.0% figure were Net Exports (green bars in chart below), which added 5.0% to the headline figure, and Inventories (gray bars), which subtracted 3.2%.  For the most part, the big changes in these categories were simply a reversal of big changes in the opposite direction in the first quarter.  Why all the volatility in these categories?  You guessed it – the tariffs.  In the first quarter, imports and corporate inventories surged as companies tried to get out ahead of the impending tariffs.  In the second quarter, imports fell as businesses worked off the inventories that had been accumulated in the first quarter.

The last chart below shows GDP growth in each quarter if we exclude the categories of Net Exports and Inventories (blue bars).  The chart also shows the contribution to headline GDP growth from Consumer Spending, which typically accounts for 67%-68% of GDP.  It’s easy to see the sharp deceleration in GDP growth over the past three quarters.  It’s also fairly easy to see that the contribution from Consumer Spending is largely to blame for the slowdown in growth.  This data confirms other economic data and anecdotal reports of an increasingly cautious consumer.  And it’s worth noting that consumer spending has been slowing even though we have not yet seen much of a bump in prices as a result of higher tariffs.  When prices rise, demand usually suffers.

The stock market’s relentless climb to high valuations continues to put greater onus on rebounds in consumer spending, economic growth and corporate earnings.  And as is unusually the case, the strength of the labor market will be key going forward.  We are hopeful that the passage of the tax bill and a reduction in trade uncertainty will help the outlook for the labor market, business investment, and consumer spending.  However, what’s good for the economy and labor market also raises the bar for interest-rate cuts, which seem to be increasingly baked into stock valuations at these levels.  The path of inflation remains of utmost importance, and we will get more data later this week.