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Another earnings season is getting underway, and the stakes are higher than usual for the newly minted bull market.
As public companies begin reporting their earnings results (including data on their revenue and sales, as well as any company-specific updates like subscriber numbers) this week, experts are warning that mediocre results may not be enough to keep up the stock market’s momentum.
That risk is exacerbated by the fact that stock valuations — analysts’ determinations about whether a stock is a good buy or overpriced — are soaring. Investors will also be paying close attention to the forward guidance companies release alongside their numbers from last quarter. These predictions about a company's future performance can move stock prices just as much as actual financial results, and right now, uncertain economic conditions mean forward guidance is more important than ever.
“In order for the recent rally to be sustainable we need to see a better outlook for earnings and improvement in the economy,” Megan Horneman, chief investment officer at Verdence Capital Advisors, wrote in a recent note to clients. “Otherwise, valuations, especially in select sectors, are too high.”
Lackluster earnings won't send stocks higher
Over the past few quarters, lackluster earnings results were enough to sustain investor confidence amid the threat of a major recession and steadily rising interest rates. As analysts reduced their forecasts to account for worsening conditions in the economy, many companies performed better than expected, even though their results wouldn't have been considered stellar under different circumstances. That gave the market a significant boost.
But now, an earnings season that isn’t a “complete disaster” isn’t enough to send stocks higher anymore, says Jeff Buchbinder, chief equity strategist at LPL Financial.
“We need something better than that," Buchbinder says. "The bar has been raised.”
Morgan Stanley equity strategist Michael Wilson echoed that sentiment in a note to clients this week, warning investors that this time around, "'better than feared' likely isn’t going to cut it."
He pointed to higher interest rates and falling liquidity (as in, less cash floating around in the market, which tends to weigh on stock prices), and the fact that stock valuations are much higher now compared to a few months ago. Wilson says this is evidence that the market will need “more confirmation” that companies can continue to perform well despite a worsening economic climate, and adds that since stocks have already priced in the possibility that earnings will be different than expected, forward guidance will be more important than usual this earnings season.
In general, analysts are expecting earnings in the second quarter for all the companies in the S&P 500 index to have fallen by about 7% compared to the same period last year, according to data from FactSet. That would be the biggest drop in three years.
Buchbinder says investors anticipate companies’ actual earnings results to be a little better than what analysts are predicting right now, which is fairly standard for any earnings season. "People are going to expect at least three to four percentage points of upside" for the second quarter, Buchbinder explains, meaning that overall earnings that are only down 2% or 3% from a year ago could be good enough to keep the market stable. On the other hand, results that are worse than investors expect could send the market down, he says.
“At higher valuations, there's more downside to earnings disappointment,” Buchbinder says. “Therefore, disappointments are punished more.”
Tech stocks in the spotlight
The potential for mediocre earnings to take a toll on stocks is especially true when it comes to the tech sector. A handful of mega cap tech companies including Microsoft, Alphabet and the artificial intelligence-focused Nvidia have been responsible for a large portion of this year’s market rally, so investors will be anxiously awaiting news about their performance for clues about whether the market can keep rising.
“Some of these companies are valued at extremely high levels,” says Michael Rosen, managing partner and chief investment officer at Angeles Investments. “The bulls would say they're justified because the prospects are really strong. And others might say, ‘yeah, but nothing grows forever.’”
Rosen points out that these high valuations make tech stocks especially vulnerable to an earnings disappointment — even if they only report a modest earnings shortfall.
“You would see a disproportionate drop in their share price should that happen,” he says.
Tech stocks are also facing headwinds in the form of high interest rates that make it more expensive to do business, along with a surge of enthusiasm around artificial intelligence that may or may not be sustainable.
“We don't know if this is the quarter when tech disappoints,” Buchbinder says. “Maybe it's next quarter, maybe it's even later than that. But it's clear to us that expectations are pretty high.”
Which market sector is expected to perform well?
While tech sector results look precarious, experts are optimistic about earnings in the consumer discretionary sector as it continues to benefit from a post-COVID-19 reopening boost.
Consumer discretionary stocks are companies that sell products that aren't necessary in the same way something like groceries are, and they tend to do well when the economy does well — think airlines, hotels and restaurants. Spending increases in this category when consumers have extra savings and good income, but it tends to dry up when economic conditions worsen.
Analysts expect earnings in this sector to come in nearly 27% higher than last year, according to FactSet. Horneman notes that much of that spike is attributable to earnings growth at a single company: Amazon.
But investors shouldn't expect that growth to last forever. Buchbinder points to a slew of economic conditions that could put pressure on the sector later this year, including more rate hikes, the end of the federal student loan payment moratorium and a weakening job market.
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