Earnings Szn

Earnings are the most important driver of stock prices over the long term.

But in the short run, the relationship between the two is fuzzy.

This week marks the unofficial end of earnings season, as nearly 90% of the S&P 500 has reported results for the fourth quarter. The index’s earnings per share are set to fall 2%, which is the first quarterly drop since 3Q 2020.

While bad on the surface, these results were not much of a surprise.

Earnings reports are backwards looking — they tell you what’s already happened, not what’s going to happen. The S&P was down nearly 20% last year, and to some extent, these results were already priced into the market.

Stan Druckenmiller — arguably one of the greatest investors of all time — has a famous quote on earnings and what they indicate about the future:

“You don’t buy when earnings are great, because what are [companies] doing when their earnings are great? They go out and expand capacity. Three or four years later, there's overcapacity and they're losing money. What about when they're losing money? Well, then they’ve stopped building capacity. So three or four years later, capacity will have shrunk and their profit margins will be way up. So, you always have to sort of imagine the world the way it's going to be in 18 to 24 months as opposed to now. If you buy it now, you're buying into every single fad every single moment. Whereas if you envision the future, you're trying to imagine how that might be reflected differently in security prices.”

In short, it pays to be contrarian. And history would indicate the quote holds up well under pressure.

Strategas Research shared a graphic depicting how earnings growth compares to equity returns over time. Since 1950, they found 11 instances when S&P earnings (green bars) were down by at least 10% for the year, the index was either flat or positive nine times.

Entering the year, first quarter’s earnings season felt like something to be feared. Many prominent Wall Street strategists warned the S&P was likely to fall during the early part of 2023 and losses were expected to be driven by earnings expectations being revised lower.

Only one of those predictions came true; earnings have been revised lower.

Since December 31st, consensus EPS estimates have come down 1.7%, per Credit Suisse chief U.S. equity strategist Jonathan Golub. Historically, the opposite happens, with earnings rising after quarter end.

Since 1998, analysts’ average estimates have tended to rise 2.8% after the ends of quarters, with estimates cut in only 16 of 98 quarters, and with nine reductions steeper than 1.7%. Except for 2020’s first quarter, when Covid-19 threw the world into turmoil, those came during the 2001 recession and the 2008-09 financial crisis.

As a result, Golub writes, excluding recessions, this has been the “worst earnings season” in 24 years. Per FactSet, consensus EPS estimates are factoring in more earnings declines in Q1 and Q2 before returning to earnings growth in Q3 this year.

With the S&P is up nearly 5% YTD, what gives?

One of the weird quirks of investing is even if you predict the economic environment exactly right, you still don’t know how the market will react.

But the answer to markets positive returns to date is likely some combination of the following:

1. Stocks can rise when earnings fall.

2. Stocks usually bottom before the worst news comes to light.

3. When a large group of people expect stocks to sell-off for the same reason, the information is likely already in market prices.

The hurdle of earnings season was cleared, even if it only required a step rather than a leap. Most companies provided outlooks for the second half of the year that allow investors to “look through” disappointing current results. A key theme companies mentioned during earnings call was a strong consumer.

Across hotels, airlines, and restaurants, commentary followed a similar tone, which was, the consumer continues to spend. And the market seems to be prioritizing a healthy consumer outlook over a bad earnings season.

For now, the anticipation of earnings season was worse than the reality.