Critical earnings season lies ahead

In the stock markets, the 4-day week has been a toss-up between recessionary headwinds and relief from falling interest rates.

In this post, we talk about the market situation and the exciting earnings season ahead from the perspective of the world's largest and most important market, the US.

In Finland, construction software company Admicom unofficially launched the earnings season yesterday. The result was in line with forecasts, but the company expects growth to slow as the economic slowdown hits the construction sector. Bankruptcies are already on the rise in the sector. Compared to our analyst Atte Riikola's expectations, there was nothing shocking in the report. In Finland, more results will trickle in towards the end of the month.

Next week, unfortunately, there will only be one What’s Up with Stonks, as I thought I'd take Easter off for real and Tuesday's post wouldn't quite be ready in just one morning. - Thus, the next post will exceptionally be released next Wednesday.

Overview of the market and the coming earnings season

Let’s get to it. It can be difficult to follow the recent economic picture, as the market movements have been rapid. To briefly summarize, at the beginning of the year there were fears of a recession, then the economy got too hot, but the fallout from the banking crisis poured cold water on the economy and now the latest indicators show a cooling off. At the same time, it’s worth noting that a potential downturn may not even come as a surprise to equities, as the downturn in earnings is already in the consensus forecasts.

This graph shows the Conference Board's Leading Indicator, which consists of several economic indicators such as new industrial orders, building permits, jobless claims or, for example, ease of access to credit. The LEI has done a pretty good job of predicting recessions, and at current levels it strongly flags a recession in the world's largest economy. And if the US economy goes into recession, the rest of the world will follow. After all, the country is the biggest source of demand for goods and services produced in the world.

 
Although the LEI is sounding the alarm, it appears to be bottoming out. This shows the six-month annualized change in the LEI. If the turnaround continues, a possible future recession is already old news.

It should be noted briefly that the Atlanta Fed's GDP Now indicator, for example, shows no signs of a recession and expects growth of almost 2% for the first quarter in the US, although in recent weeks this indicator has lost momentum.

 
The economy isn’t a huge homogeneous monolith, but a heterogeneous organic machine whose parts run at different speeds. In the same way that the stock market isn’t a stock market but a market of different stocks that are driven by different drivers. This is well reflected in the purchasing managers' indices. The US manufacturing PMI has droppen in a range that has generally signaled an economic downturn. By contrast, the services sector index argues for a growing economy at the same time, although the latest reading fell quite a lot. Manufacturing accounts for just under 20% of the US economy, so the services sector is swinging the baton. It will be interesting to see if the services also cool down in the spring.

The tight labor market has been a persistent example of a hot economy, but there are signs of relief there too. The number of job vacancies in the US fell below 10 million in February, according to the latest release. There are still 1.7 job vacancies for every unemployed jobseeker, whereas in the recession the opposite is true, with several jobseekers for every job vacancy. But in any case, the cooling of the labor market should gradually reduce wage pressures and thus inflation. Indeed, wage growth for workers changing jobs has recently slowed down. The ADP employment data released yesterday also missed expectations by a wide margin, with news of weakening employment.



The cooling winds of the economy are reflected in the interest rates that partly determine the valuation of equities. The financial market's ultimate gravitational force, the US 10-year bond rate has fallen on top of last fall's stagflationary trends from 4% to 3.3%.

This graph shows the 10-year interest rate and the forward-looking P/E ratio of the S&P 500 index. What I am trying to suggest here, in layman's terms, is that if earnings growth and growth profitability of S&P 500 stocks remain roughly flat over the next few years, while inflation and hence interest rates calm down, the current valuation would be at the upper end of an acceptable range.



In a bit more complicated terms, there is generally no room for upside on valuations based on fundamentals. For the S&P 500, the neutral P/E multiple is around 19x compared to the forecast result after 12 months, assuming the next two years of consensus earnings hit the mark (which they rarely do) and earnings growth fades from there to 3% from a couple of years ahead into perpetuity. In addition, the valuation is influenced by an assumed return on equity of 17% and an assumed long-term risk-free interest rate of 3%. Anyone can easily make these assumptions in their own head or in Damodaran's excels like I do, but for my taste these are quite sophisticated assumptions.



However, there is no room for too many negative surprises. If interest rates continue to fall in the absence of a deeper economic downturn, we can announce with the benefit of hindsight that those bottoms were indeed the last fall in the light of that information.

If index valuations don’t seem attractive, but an investor wants to stick their hand in the trash that others don't want to touch, then bank stocks are now out of favor. Their relative valuation has plummeted compared to stock market indices. An opportunity has therefore arisen for the value investor to make a bargain. European bank shares are priced at 6.5 times forward earnings, US banks at 7.3 times forward earnings. (Another entertaining feature of banks for the thrill-seeking investor is that they can collapse virtually in a weekend, whereas normal companies come with warning signs over several years.)



Now to the results. As I already hinted, the decline in earnings is a consensus forecast and therefore not a surprise for the market. The earnings season is critical in the sense that if results disappoint or surprise positively, the assumptions just shared about the fair value of the index can be scrapped. S&P 500 results are expected to fall by 7.4% year-on-year in the first quarter and by a further 5.4% in the second quarter. Earnings declines will hit across the board, apart from energy companies, defensive consumer companies and industrial companies, which are expected to post higher earnings. Around 60% of the S&P 500 companies' turnover comes from the US. The five largest companies in the index account for more than 10% of total earnings. Among the top 5, Apple and Nvidia's results are looking good, but judging by their floating share prices, investors' attention is on future growth stocks. Analysts have politely lowered the S&P 500's earnings forecasts again nicely ahead of the earnings season, to make it easier to crawl over them.



At the index level, earnings growth should return in the fall and full-year S&P 500 EPS should hit around $220 as per current forecasts.

One problem consistently raised in the results is the sustainability of record high margins. This graph shows the S&P 500's operating profit margin by quarter and the corresponding figure excluding the super-performing technology sector. Consensus expects profitability to fall from record levels to pre-pandemic territory, but to rise again to new records in the coming years. Of course, a more cautious observer may disagree with the consensus on this.

 
Of course, one quarter isn’t that critical for a shareholder, but it will be interesting to read companies' comments on economic developments. The stock market is driven by expectations of the future, so it only matters what drives future predictions.

So, there’s my review. Results have started to come in from the lesser-known companies in the US. However, in practice the earnings season will really kick off at the end of next week with the big banks.

Thank you for reading the post! Read analysis and make good stock picks!