Earnings Are Better Than Expected. Why Stocks Are Still Falling.


Early third-quarter earnings results have been strong so far, with most companies beating analyst expectations.

Not that it is doing much for their stocks.

The aggregate earnings result on the S&P 500 thus far has been just over 5% higher than the aggregate estimate from analysts covering companies in the index, according to Credit Suisse. The majority of companies are beating estimates by any margin at all. 

Despite those results, the average stock price reaction the trading day after a company beats on both sales and earnings per share is down 0.4%, according to Evercore.

Stocks have traded even worse for companies that miss estimates—firms that have missed on both sales and EPS have seen their shares drop almost 7% on average this earnings season. 

In the past five years, a beat on top and bottom lines has caused a gain of almost 1%, on average.

The reason stocks seemed to be getting punished no matter what is all about forward expectations. 

In the macroeconomic picture, demand is only weakening. The Federal Reserve is rapidly lifting interest rates to curb demand to reduce the rate of inflation. And markets are well aware that higher rates often take a few months or quarters to take full effect on the economy.

That means more reduction to consumer demand and lesser price increases. In the near-term, sales and profit margins are likely to drop from current estimates.  

“Earnings season might not be bad, but [earnings] being strong enough to reverse this tide will be a tough go,” wrote Yung-Yu Ma, chief investment strategist at BMO Wealth Management. 

Earnings estimates could drop from here. Fourth-quarter EPS estimates have fallen not even 1% since September, according to Credit Suisse. Historically, estimates for that quarter tend to drop as much as 5% in the months leading up to companies’ reports. And this time could bring about an even larger drop in expectations, given the current economic conditions. 

Consistent with that, management teams aren’t signaling confidence about the next few quarters even though they are posting better-than-expected results. Recently, a net 35% of S&P 500 companies have decreased EPS guidance, according to 22V Research. That means the percentage of all companies reducing guidance minus those increasing has been at around 35%. That is the highest level since around 2015.  

The potential for lower earnings from here should indeed dent stocks since they are still priced expensively.

The S&P 500’s aggregate forward price/earnings multiple is just under 16 times, down from just over 20 times to start the year. But that is not necessarily cheap, given that long-dated bond yields have risen by several times where they began the year. Higher bond yields make future profits less valuable.

Many on Wall Street see equity valuations as still too high. With such high prices, companies have a higher bar for earnings—they must beat profit forecasts by a particularly wide margin to keep market participants interested in buying stocks. 

The market just has a lot more to sort out before companies can win over investors again. 

Write to Jacob Sonenshine at jacob.sonenshine@barrons.com

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