U.S. earnings outlook: has the stock market set the bar too high?
With corporate earnings, the downside of exceeding expectations is that a single quarter of better-than-forecast results ends up nudging the earnings performance bar higher for coming quarters. It’s often not about the seemingly impressive numbers that a company may deliver in a given quarter, it’s how those numbers stack up against previous quarters’ results plus any guidance a company provides on future earnings. At some point, however, earnings may fail to maintain previous growth rates, potentially leaving investors disappointed.
That’s among the scenarios that could play out heading into the opening of the next U.S. earnings season in mid-July, given currently lofty expectations. For investors, risks could emerge if earnings fall short of consensus forecasts through the rest of this year, although we see an abundance of attractively valued market segments that we believe could offer a margin of relative safety in case of a market downturn.
Can the momentum from Q1’s strong earnings continue?
The postpandemic recovery in quarterly earnings growth has continually set the expectations bar higher, providing lift for the stock market and pushing valuations above their historical average. As of March 31, prior to the start of the recently concluded earnings season, analysts surveyed by FactSet had forecast that companies in the S&P 500 Index (S&P 500) would post first-quarter earnings growth of 3.4%. As in other recent quarters, the outlook improved as earnings season progressed, resulting in a higher growth rate of 5.9% by the time all results were in. That outcome marked the strongest year-over-year growth rate since the 9.4% figure recorded in the first quarter of 2022.
The S&P 500 Index set a record high on June 13; the next day, its 12-month forward price-to-earnings ratio stood at 21.0—moderately above the five-year average of 19.2 and well above 10-year average of 17.8, according to FactSet.
Stock prices and earnings estimates tend to move together over time
Source: FactSet, as of 6/14/24. The S&P 500 Index tracks the performance of 500 of the largest publicly traded companies in the United States. It is not possible to invest directly in an index. Earnings per share (EPS) is a measure of how much profit a company has generated calculated by dividing the company’s net income by its total number of outstanding shares. YoY refers to year over year. No forecasts are guaranteed. Past performance does not guarantee future results.
The tough road ahead to meet earnings expectations
Looking ahead to the next round, second-quarter earnings were expected as of June 21 to accelerate to a 8.8% growth rate relative to the same quarter a year earlier, according to FactSet’s consensus estimate. For full-year 2024, expectations were even higher, with a 11.3% forecast, followed by a 14.4% forecast for 2025.
While actual earnings growth may indeed meet these expectations, it’s worth considering three potential obstacles that could lead to slower-than-forecast earnings growth and downward pressure on the market.
1 Tougher year-ago comparisons—We’re now in a period in which 2024 earnings are being measured against the accelerated pace of gains seen in comparable year-ago quarters in 2023, so earnings have a steep road to climb in order to achieve double-digit growth. A year ago, the bar had been set lower, as the growth rate in mid- to late 2022 stalled modestly before picking back up in 2023. Expectations are high now that we’ve seen four consecutive quarters of year-over-year growth since 2023’s second quarter.
2 Earnings expectations for the Magnificent 7 stocks—and one name in particular—have become increasingly challenging—A relatively small number of mega-cap names has come to dominate the U.S. stock market, as evidenced by the seven technology- and growth-oriented stocks known informally as the Magnificent 7. In 2023, those seven stocks’ average total return gain of 104.7% accounted for 62.2% of the S&P 500 ’s 26.3% total return. With such dominance, a failure by any one or two of those seven stocks to meet earnings expectations could cause a proportionately large ripple that could exert downward pressure across the broader market.
In particular, one stock in the group of seven is a relative newcomer in the mega-cap space, as rapid earnings growth in 2023 propelled the company’s shares upward at a dizzying rate, lifting its market capitalization to levels alongside those of more established names. Given the rapid earnings gains that this company experienced in 2023, it could be hard to replicate the same year-over-year growth rate through the rest of this year. Excluding that one company’s earnings growth in this year’s first quarter, the information technology sector’s overall earnings growth rate would have been less than half of the 26% that the sector actually recorded.1
While we expect the build-out of emerging artificial intelligence technology to continue supporting the tech sector Magnificent 7 stocks throughout 2024, some moderation of earnings growth is a possibility that we don’t believe should be ignored, especially for that one company that experienced such rapid recent growth.
We believe that communication services could face a similar challenge to repeat as the top earnings growth sector in this year’s second quarter. In the first quarter, communication services posted an overall 33.8% earnings growth rate, according to FactSet, bolstered in part by an easy comparison versus its –13.0% earnings growth rate in the first quarter of 2023.
3 Utilities’ Q1 tailwind may dissipate in Q2—Among all 11 sectors, the typically low-profile utilities sector trailed only communication services in this year’s first quarter with a 31.5% earnings growth rate. However, that result came after the sector posted a weak –13.0% earnings decline in the year-ago quarter, and the most recent quarter’s growth was narrow. Absent the electric utilities subindustry’s earnings gains due to what appear to have been one-time headwinds in the year-ago comparison period, overall earnings growth across the utilities sector would have been a middling 4.9%, according to FactSet. Without a recurrence of the latest quarter’s favorable comparison for electric utilities, utilities sector earnings growth could normalize going forward, in our view.
Where we see top opportunities in U.S. equities going forward
While our view of U.S. equities remains modestly positive, we believe that a good measure of optimism is already baked into stocks from both earnings estimates and valuation perspectives. As a result, we’re focused on identifying stocks with upside potential combined with characteristics that could offer a margin of relative safety in case of a market downturn.
If earnings over the rest of this year do end up falling short of expectations, we’re inclined to lean even more heavily into our current emphasis on quality and value at the factor level. We believe that companies with quality characteristics—strong balance sheets, durable profitability, high returns on equity, and low capital needs—could maintain an edge over peers in their industries, given that borrowing costs remain high owing to today’s higher-for-longer-interest-rate environment. As for the value factor, we’re emphasizing screening stocks based on valuations such as price-to-book or price-to-earnings measures and minimizing exposure to unprofitable or expensive stocks.
At the sector level, we favor tilting toward information technology, healthcare, and utilities. We view information technology as a leader in terms of quality characteristics, based on the sector’s overall solid profit margins, high returns on equity, and strong balance sheets. In healthcare, we’re drawn by improving earnings estimates, discounted valuations, and defensive characteristics. Across the utilities sector, we see an abundance of attractively valued companies that could stand to potentially benefit from any market rotation toward the value equity style and from any further rise in commodity prices. Looking beyond factor and sector exposure, we see attractive opportunities in particular at the mid-cap level and favor core-to-value equity-style exposure.
Whether or not earnings meet expectations through the rest of 2024, we believe that the current preferences we've outlined in our latest edition of Market Intelligence leverage compelling and reasonably priced opportunities that offer the potential to provide upside participation in a rising market as well as a measure of downside protection should the stock market’s generally positive recent momentum begin to stall.
1 “Q1 2024 Earnings Review: Solid Results Set The Stage For 2H Broadening,” MRB Partners, Inc., 5/28/24.
Important disclosures
The views expressed in this material are the views of are those of Emily R. Roland, CIMA, and Matthew D. Miskin, CFA, of John Hancock Investment Management Distributors LLC, and are subject to change without notice at any time based on market and other factors. All information has been obtained from sources believed to be reliable, but accuracy is not guaranteed. This commentary is provided for informational purposes only and is not an endorsement of any security, mutual fund, sector, or index, and is not indicative of any John Hancock fund. Past performance does not guarantee future results. Diversification does not guarantee a profit or eliminate the risk of a loss.
Investing involves risks, including the potential loss of principal. Financial markets are volatile and can fluctuate significantly in response to company, industry, political, regulatory, market, or economic developments. The information provided does not take into account the suitability, investment objectives, financial situation, or particular needs of any specific person.
The S&P 500 Index tracks the performance of 500 of the largest companies in the United States. It is not possible to invest directly in an index. The forward price-to-earnings (P/E) ratio is a stock valuation measure comparing the current share price of a stock with the underlying company’s estimated earnings per share over the next 12 months. Earnings per share (EPS) is a measure of how much profit a company has generated calculated by dividing the company's net income by its total number of outstanding shares. Return on equity (ROE) is a measure of profitability that calculates how many dollars of profit a company generates with each dollar of shareholders’ equity. Market capitalization is the value of a corporation determined by the market price of its issued and outstanding common stock.
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