Daniel H. from Cleveland, OH asks: Hi Mitch, as the earnings season kicks off, I wonder if you see strong earnings as make or break for the markets. Since stocks have increased so much, it feels like even the slightest disappointment could lead to a crash. What are your thoughts?
Mitch’s Response:
Thanks for writing, Daniel. Your question makes sense – since last October, the S&P 500 is up over +30%, and the index has reached over 30 all-time highs in 2024 alone. In aggregate, the index is priced at roughly 22x earnings compared to a long-term average of 16x. Based on this data, one could logically conclude that expectations for strong earnings growth are high, or maybe even too high. Indeed, according to data compiled by Bloomberg, expectations for forward 12-month earnings are at record highs.1
We’re seeing similar ‘confidence’ in earnings based on earnings revision numbers, which typically decline during a quarter and right before reporting. For Q2 2024, however, estimates have been holding up far better than other recent periods. In the three-month period from the start of the quarter through June 30, Q2 estimates for the S&P 500 index fell the least relative to comparable periods of other recent quarters. We also know that analysts have been upgrading more profit estimates than downgrading them.
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As you allude to in your question, these high expectations could open the door for downside volatility should earnings disappoint.
I agree with the thinking here, and we already know from the first quarter that the market did not necessarily reward even the companies that beat earnings. In Q1, more than 80% of S&P 500 companies beat earnings estimates, but the median stock underperformed the S&P 500 index by 12 basis points on the day earnings were released. With expectations running high in Q2, I would not be surprised if we saw a similar pattern.
One key factor missing here, however, is that the S&P 500’s elevated valuation is being slightly obscured by the mega-cap technology companies that trade at higher multiples. Near the end of the quarter, for example, the Magnificent Seven traded at roughly 34x earnings, while the other 493 stocks in the S&P 500 were closer to 17x earnings. The stakes are arguably higher for those companies trading at higher-than-average multiples.
At the end of the day, earnings matter greatly to stock market performance over time. But remember that earnings season gives us backward-looking data, i.e., how profitable companies were over the previous three months. Stocks tend to look ahead, so it’s more about how investors expect earnings to evolve over the next few quarters, not the previous one.
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Disclosure
2 ZIM may amend or rescind the “Using Market Volatility to Your Advantage” guide for any reason and at ZIM’s discretion.
3 Zacks.com. 2024. https://www.zacks.com/commentary/2297407/3-key-things-to-know-about-the-q2-earnings-season
4 ZIM may amend or rescind the “Using Market Volatility to Your Advantage” guide for any reason and at ZIM’s discretion.
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