Are Corporate Profits Falling Off a Cliff?
Are Corporate Profits Falling Off a Cliff?
What will happen to US company earnings and how will markets react
Hey everyone, welcome back to another edition of the 5i Research newsletter. In this post, we are going to analyze US corporate profits against the broader stock market, and whether a decline in corporate earnings has been priced in.
Let’s dive in!
Earnings Decline Fears
The stock market has been facing criticism over concerns of a potential recession, growth slowdown, and other economic uncertainties that continue to impact the global economy. A major concern for investors has been the potential for declining company earnings, which could hinder the overall performance of the stock market. The question remains: how much of these fears of earnings declines have already been priced into the markets?
Has the Market Priced in the Potential for an Earnings Decline?
The market and corporate profits tend to follow each other over time. While there are instances where corporate profits decline first and then the market follows, or the market falls first and then corporate profits decline, recently, the market corrected throughout 2022 as earnings stagnated. This signals to us that the market anticipated a fall in earnings as inflation and rising interest rate headwinds would take hold, but earnings merely flatlined. Further earnings contraction from here is certainly possible, but the market declines have likely already priced in this possibility.
Corporate Profits and Market Divergence
Looking at an alternative viewpoint of the same data, the year-over-year percentage change in US corporate profits and the S&P 500 largely correlate with each other. One major divergence we have noted is that while the markets (blue area) declined as much as 20% on a rolling one-year basis, US earnings (black line) were actually up about 5% on a rolling one-year basis. This means that the annual change in the markets of (20%) signaled a large mismatch with earnings.
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Annual Earnings and Market Changes - Spread
The spread between the annual change in US corporate earnings and the market is interesting to note, and whenever the spread was green (earnings growing faster than the market) and it peaked, this typically signaled a market bottom, whereas areas of red (markets growing faster than earnings) indicated a market that was becoming overheated. Based on a good track record from this indicator, it seems as though the market has effectively discounted a potential decline in earnings, and in fact, the lack of earnings decline has placed the market in an ‘undervalued’ zone in our opinion.
Overall, the lack of a material decline in earnings has made the S&P 500’s valuation more attractive, as marginally growing corporate earnings of ~5% have outweighed a large decline in the S&P 500 of (~20%). As earnings season progresses, there is increasing encouragement by companies’ earnings and resiliency through these challenging times, which in our view provides a bull case for increasing momentum in the stock market throughout the rest of the year and into 2024.
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