Earnings still matter

Bottom Line

There’s a Wall Street chestnut that one surprisingly aberrant data point is a blip, two are a fluke but three in a row start a new trend. The decline in inflation, once thought to be on a glide path to the Federal Reserve’s 2% target last year, has stalled over the past few months and seems to be re-accelerating. Once, the consensus view was that the U.S. economy was heading into recession at the end of 2023. But the labor market has been strong and hard landing forecasts have disappeared. The current debate is whether the economy will have a soft landing or no landing at all. Fed officials, who assured us just last month to expect three interest-rate cuts this year, are now furiously back peddling, with some warning their next policy decision may be to hike rates.

With interest rates rising sharply, the uncertain timing of potential cuts, volatility rising and elevated price/earnings (P/E) multiples beginning to contract, the first quarter’s nascent revenue and earnings reporting season has taken on outsized importance.

First-quarter reporting season unfolds The reporting season for the S&P 500 kicked off a week ago. According to FactSet, revenue growth is expected to rise 3.4% year-over-year (y/y), down from an expected gain of 4.4% in late December. That would be roughly in line with the fourth quarter’s actual increase of 3.7% y/y and would mark the 14th consecutive quarter of y/y revenue growth for the S&P.

Earnings per share (EPS) are expected to rise 3.2% y/y in the first quarter of 2024, down from an expected gain of 5.7% in late December. Although that would mark a sequential decline from the actual fourth-quarter gain of 8%, it would also mark the third consecutive positive quarter, after three consecutive quarters of declining earnings. So, the earnings recession appears to have troughed in the second quarter of 2023. Importantly, company managements in recent months have issued negative earnings guidance for the first quarter that was 2.4 times greater than those who offered positive guidance. That’s not unusual, as many companies attempt to manufacture an upside surprise by talking Wall Street down ahead of their quarterly report. In fact, according to UBS, the long-term average upside surprise over the past five years is 1% from revenues and 4.8% for EPS.

To date, we’re about 13.5% of the way through the reporting season. Revenues have risen about 4.3% y/y and earnings are up about 7.3%.

State of the economy’s landing: hard, soft or no? The Commerce Department will flash first quarter GDP Thursday. While economic growth should be positive, it could be sequentially slower at about 2.4% for the second consecutive quarter, compared with 3.4% for last year’s fourth quarter and 4.9% in the third. (Federated Hermes is estimating 2.2% GDP growth for this year’s first quarter; the Blue Chip consensus is at 2.1%; the Bloomberg consensus is at 2.5%; and the Atlanta Fed’s GDP Nowcast was increased recently to 2.9%). Importantly, the Blue Chip consensus has removed any remaining negative quarterly GDP estimates in 2024, which suggests that a potential recession forecast is off the table. The raging economic debate now is whether the economy will experience a soft landing with slower positive GDP growth, or will it re-accelerate later this year? We’re still in the soft-landing camp.

Financial markets repricing Benchmark 10-year Treasury yields soared from an overbought 3.81% on February 1 to an oversold 4.69% earlier this week. Technically speaking, there isn’t much overhead resistance between here and 5%, so we could see a re-test of that October 2023 level in coming months.

The volatility index (VIX) has surged from an overbought 13 on March 21 to an oversold spike of 21 today, as investors have become increasingly unnerved by growing geopolitical risk in multiple theatres.

Equity investors, however, largely ignored these developments over the past five months, with the S&P soaring 10% in the first quarter of 2024—the market’s best opening period since 2019—amid a powerful 28% rally since October 27. But the S&P declined nearly 6% over the past three weeks, in line with our forecast for a healthy, long-overdue and much-needed 5-10% equity market correction. The increase in Treasury yields necessitates a narrowing of P/E multiples.

Barbell-shaped year for stocks in 2024 After a powerful first-quarter performance for stocks, we envisioned a choppy second quarter due to Fed-related uncertainty, with a volatile third quarter to follow, as investors begin to price in their election worries. But we’re still expecting a strong post-election, sigh-of-relief rally to finish the year in record territory.

Wither the Mag 7? We still believe that the so-called Mag 7 stocks will disproportionately shoulder most of the damage from this correction. Over the past 18 months through March 31, the Mag 7 collectively soared 99%. While this drove the S&P up 37%, the “Forgotten 493” rose a paltry 22%. Consequently, we’ve been expecting a reversion to the mean of this valuation imbalance. The outperformance of growth versus value has exceeded a two-standard deviation event for only the third time in the last 40 years: the bursting of the Y2K tech bubble in 2000, the reversal of the Covid bubble in 2020 and today. So, we expect this rotation to continue to broaden.

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