Analysts expect S&P500 companies to report solid earnings for the third quarter, but they are not expected to cause a major stock market surge.
PepsiCo is the first to report on Tuesday. JPMorgan Chase, Wells Fargo and other financial giants will follow on Friday.
FactSet projects that the third quarter earnings per share of S&P 500 firms will grow 4.1% over last year, or just under $60.
The rise in sales is expected, and it will be accompanied by a 4.7% increase. This seems reasonable when you consider that economic growth has slowed to single-digit rates.
Costs rising, margins being squeezed
Although companies have been able to maintain product costs, wages and other employee benefits continue to increase.
Profit margins are squeezed by these increasing costs, which prevents businesses from growing as fast as they might have hoped.
Technology is the fastest growing sector, and companies such as Nvidia or Microsoft are leading this growth.
Nvidia benefits from the increasing demand for AI chips that are crucial to AI-enhanced Cloud Services.
Microsoft also capitalizes on AI cloud solutions, as businesses are willing to pay more for these cost-saving options.
Meta Platforms also sees gains using AI in order to increase user engagement and revenue.
Overall earnings are affected by cyclical sectors
Other sectors, including the tech sector, are slowing down overall S&P 500 earnings growth.
Earnings declines will be seen in cyclical or economically sensitive sectors, such as consumer discretionary and industrials.
Oil prices are currently lower than in the third quarter last year, and this is also affecting materials and energy.
Analysts at Evercore point out that these sectors are the main drag on earnings growth in the Index.
The subdued forecast is due to the sluggishness of sales, which are affected by changes in economic conditions.
Expect earnings to be better than expected, but not a big surge
What’s the good news? The good news is that companies are likely to surpass analysts’ earnings expectations.
In the past, companies have a tendency to exceed quarterly forecasts by just a few points.
The trend is consistent with the period since the financial crises, but most recently during the 2021 pandemic recovery, earnings exceeded 20%.
Wall Street has a better understanding of corporate profits and the economy, so these massive surprises in earnings have dwindled.
Stocks will likely not move much higher even if earnings are better than expected.
S&P 500 is up about 20% this year. This is due to a modestly-growing economy, lowered inflation and efforts by the Federal Reserve to keep growth going.
The S&P 500 has seen gains in every sector year to date, and the price-to earnings (P/E ratio) of the index is now over 21 times the forward earnings.
Stocks look expensive because they are at the upper end of their recent range.
Market potential is limited by high valuations
Stocks could gain modestly if companies provide optimistic forecasts of earnings or increase guidance.
Even a modest upward revision to earnings expectations will not move the markets much, as the P/E ratio is already high.
If, for example, expected earnings per share of the S&P 500 in the coming four quarters increased by 3% to $272, from $265 at the moment, then the index still traded for a high 21 times earnings. This leaves little room for stock prices to increase.
Companies that fail to meet expectations, or provide cautious forecasts are not tolerated.
As Citi strategist Scott Chronert puts it,
Our earnings resilience hypothesis is supported by beats and revisions that are smaller than normal. However, the valuations have changed. Fundamental mistakes are less likely to occur.
Summary: While American companies have performed well and earnings are likely to exceed expectations, it is not enough to drive the stock markets significantly higher over the next few months.
This year’s rally, which has seen the S&P 500 rise by 20 percent this year, has pushed prices to a point where it is difficult to justify further increases unless earnings and economic conditions improve substantially.
As we enter the earnings season for the third quarter, it appears that the market is in a hold pattern with a limited upward movement.
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