What Bear Market? Stock Earnings Forecasts Have Remained Healthy

Jason De Thomasis |

But high inflation and rising rates could mean expectations are too rosy.

Sandy Ward

Mentioned: Microsoft Corp (MSFT)

Blame the newly minted bear market in stocks on a multitude of factors, but corporate earnings isn’t one of them. At least not yet.

Even as investors grow more concerned about the risk of an economic slowdown, analysts have still been increasing their forecasts for company earnings in the second half of the year.

Despite the strong headwinds and deep investor pessimism, Wall Street analysts are projecting a rosier picture of corporate earnings and therefore the price investors should be willing to pay for those earnings, discounting the chances of recession. The risk for stock investors is that those earnings forecasts are overly optimistic, which in turns could lead to another downturn for stocks, or at the very least, make it that much harder for the market to rebound.

Investors Think Stock Earnings Forecasts Are Incorrect

It’s not unusual to see a disconnect between the views of investors in the market and analysts’ forecasts.

Not all market-watchers are convinced that the stock analysts are correct. “Investors may be ahead of the analysts,” says Ed Yardeni, president and chief investment strategist at Yardeni Research. “They’ve concluded the analysts are delusional and they aren’t going to pay as much” for stocks, he says.

When it comes to the outlook for earnings, “The jury is still out,” Yardeni says. “Consumers are still spending and profit margins are holding up. But never discount a recession.”

Factor in the Price/Earnings Ratio

Earnings expectations are one the most important variables when it comes to assessing the performance of both individual stocks and the broader market indexes. When expected earnings are compared with stock prices, those price/earnings ratios—also called a multiple—offer a sense of whether an individual stock or broad market index is considered overvalued or undervalued in relation to other stocks or indexes and based on historical trends.

In a broad perspective, it can also provide a snapshot into what part of the business cycle the economy is in, whether an expansion is peaking or beginning. The most commonly used versions of the price/earnings multiple are determined by taking the current price level and dividing by either forward estimated earnings or trailing-12-month earnings.

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During times of significant market swings, analysts will sometimes look under the hood at the broad trend in stock market multiples.

When multiples are expanding, it's a sign of confidence that companies’ earnings and cash flows will be increasing and investors are willing to pay a higher price for those profits. Conversely, when multiples contract, investors are discounting deteriorating earnings and demanding lower prices for those earnings.

Bear Market Trends Can Affect Stock Earnings

The stock market found itself in official bear market territory, declining more than 20% from its most recent peak. The S&P 500, from which many investors base bear and bull market readings, closed Monday’s session down 21.82% from its Jan. 3 high. Likewise, the Morningstar US Market Index fell 22.97% from its high on Jan. 3, the largest pullback since the coronavirus selloff.

Market Pullbacks Graph

 

Driving the latest leg of the selloff was concerns that the Federal Reserve will have to move even more aggressively than expected to clamp down on inflation through higher interest rates. The Fed’s policy-setting committee meets this week.

The selloff in stocks in 2022 has been characterized by falling prices but stable earnings expectations. The result: a swift contraction in multiples.

The S&P 500 broad market index’s forward price-earnings multiple topped out at 23.2 in early September, fell to 21.4 in January, and now hovers around 16.5 times this year’s earnings and 15 times next year’s earnings. That’s within the historical range of between 15.5 and 16.5 times forward earnings in the past 25 years. Prior to September’s high reading, the forward multiple rose to a high of 19.0 on Feb. 19, 2020, prior to the pandemic lockdowns. It plummeted to a low of 12.9 on March 23, 2020, before resuming its upward trajectory.

Underlying this trend, industry analysts see the S&P 500 companies producing earnings of $227.91 for this year and $249.95 for full year 2023, according to FactSet. That’s up from $206.21 posted in 2021.

Stock Earnings Estimates Increase in Third and Fourth Quarters

While analysts have slightly decreased earnings estimates for the second quarter, they have also raised estimates slightly for the third and fourth quarters, according to the data provider.

“Earnings estimates are holding up and going up,” says Matt Maley, chief market strategist at Miller Tabak & Co., an investment research firm. “Analysts are not cutting their earnings forecasts.”

S&P 500 vs Forward Earnings Per Share Graph

 

The rise in forward earnings estimates comes despite worsening inflationary pressures and a growing concern about a softening economy. A surging U.S. dollar is also hurting corporate bottom lines because it makes goods sold abroad more expensive. The U.S. Dollar Index is up 9.63% and hit its highest level in 20 years in May.

Inflation Affecting the Market

Maley contends continued higher inflation will lead to further erosion in the market multiple, maintaining that its expansion was artificially fueled by increased levels of government stimulus. The Fed’s easy money policies also added to risk-taking and leverage in the market, pushing margin debt to new highs.

“The stimulus led to a disconnect between the level of the stock market and its fundamental value,” says Maley. “The Fed’s liquidity pushed asset prices higher.”

He points to lowered outlooks for gross domestic product—the Atlanta Fed’s GDPNow estimate on first-quarter gross domestic product was revised down to 1.3% on June 1 from 1.9% on May 27—and Microsoft’s (MSFT) recent rare pre-announcement lowering its outlook for fiscal fourth-quarter revenue, net income, and margins as a “big red warning flag.” Microsoft blamed the strong dollar for its woes.

“As we go through June, we will see more companies pre-announce,” Maley predicts.

Backing that view up is analysis from Yardeni Research showing 20 of the 100 industries it covers have begun to show falling forward earnings estimates, noting “they are mostly consumer-related ones that may be experiencing margin compression.” The industry logging the biggest year-to-date decline in forward earnings estimates is casinos and gaming, down 33%.

Sector Returns Graph

Source: https://www.morningstar.com/articles/1098075/what-bear-market-stock-earnings-forecasts-have-remained-healthy?utm_source=eloqua&utm_medium=email&utm_campaign=newsletter_smartinvestor&utm_content=36860