Spooky (Earnings) Season

With Halloween just around the corner, there is no shortage of eerie TV shows to indulge in. I recently started watching a show called “Bodies” on Netflix, a murder mystery set in London in four different time periods: late-1800s, 1940s, 2023 and 2050. In each of the four time periods, a detective tries to solve the exact same murder case. Advances in technology and social norms help each detective to approach the case a bit differently. It’s not just a matter of repeating the past. In markets and investing, too, we cannot “crack the code” simply by repeating the past.

In The Psychology of Money, Morgan Housel writes, “History helps us calibrate our expectations, study where people tend to go wrong, and offers a rough guide of what tends to work. But it is not, in any way, a map of the future.”

We can’t look to any one past period to guide our approach now, as investors face “higher for longer” interest rates, persistent inflation, and most equity return for the year stemming from only a handful of stocks. What we can do is look to the past as a guide—considering, for example, the inflation of the 1970s, the tech bubble of the early 2000s, and rate-hiking cycles in multiple decades.

Corporate earnings is one of the most important focus points as we seek to, as Housel put it, “calibrate our expectations.” Our view is analysts have overly high expectations.

Overly Optimistic Earnings

With much uncertainty in the markets, earnings are a big question among investors this quarter. More than half the stocks in the S&P 500 Index are negative year-to-date while only about 27% are outperforming the S&P 500’s approximately 11% return.

A slowing economy and lower inflation have brought earnings growth to a halt for S&P 500 companies over the past year. Analysts expect a pickup in third-quarter earnings and—even more idealistically—double-digit increases starting in Q4. We believe any improvements will be muted given the overall economy reaching a plateau.

The chart below illustrates the stagnant earnings that we’ve seen over the past year and analyst estimates in the year ahead. The grey line excludes mega cap stocks which includes companies like Apple, Meta, and Amazon—which have been the star earners. (About half of the 10% earnings growth that is expected over the next year is expected to come from these mega cap names.)

Buyer beware! Unrealistic earnings predictions also make these stars vulnerable to poor earnings reactions, causing increased volatility along the way.

Among companies reporting earnings so far for Q3, we have seen companies boost their third quarter revenues by raising prices—which isn’t necessarily sustainable. We also think consumer health will slowly deteriorate given declining real incomes, resumed student loan payments, a rise in auto loan defaults, high interest rates, and depleting excess savings from Covid-era stimulus. We believe these factors will lead to a slower-growing economy in the coming quarters and that earnings expectations will prove to be overly optimistic.

Diversification remains crucial in managing the uncertainty in the market.

Positioning is Key

As a result of our slower economic outlook, we are positioned to focus on less economically sensitive large cap stocks, while minimizing exposure to small companies, cyclical value, and high-valuation growth segments of the market. This translates into favoring quality companies with higher return on assets, equity, and invested capital. We also favor companies with higher interest coverage and debt coverage ratios.

As Brian Andrew mentioned in his commentary last week, with uncertainty in stocks in the short term and greater opportunity in bonds going forward. Trimming stocks in favor or bonds may be warranted. A conversation with your advisor can help guide that decision taking into account your long-term financial goals.