After the turbulent start to the year on the stock markets, traders are confronted with a number of risks, from economic fears to interest rate uncertainty and election fears. But perhaps the most important variable in whether stocks can keep rolling is coming back into the spotlight this week: corporate earnings.
The S&P 500 Index is up about 20% in 2024, adding more than $8 trillion to its market cap. The gains are largely due to expectations of monetary easing and robust earnings prospects.
But the tide may be turning as analysts scale back their expectations for third-quarter results. Companies in the S&P 500 are expected to report a 4.7% year-over-year rise in quarterly profits, according to data compiled by Bloomberg Intelligence. That’s down from 7.9% forecasts as of July 12 and would be the weakest increase in four quarters, BI data shows.
“Earnings season will be more important than normal this time,” said Adam Parker, founder of Trivariate Research. “We need concrete data from companies.”
In particular, investors are looking to see whether companies are delaying spending, whether demand has slowed and whether customers are behaving differently due to geopolitical risks and macroeconomic uncertainty, Parker said. “With so much going on in the world, corporate earnings and forecasts will be particularly important now,” he said.
Reports from major companies begin this week with results from Delta Air Lines Inc. due on Thursday and JPMorgan Chase & Co. and Wells Fargo & Co. planned for Friday.
“Earnings seasons are typically positive for stocks,” said Binky Chadha, chief U.S. equity and global strategist at Deutsche Bank Securities Inc. “But the strong rally and out-performing positioning early in (this earnings season) suggest a muted market reaction.”
There are many obstacles
The obstacles investors are currently facing are no secret. The US presidential election is just a month away. Democrat Kamala Harris and Republican Donald Trump are engaged in a tight, bitter race. The Federal Reserve has just started cutting interest rates, and while there is optimism about a soft landing for the economy, questions remain about how quickly central bankers will reduce borrowing costs. And a worsening conflict in the Middle East is raising concerns that inflation could rise again, with the price of West Texas Intermediate oil rising 9% last week, the biggest weekly rise in March 2023.
Read more: The risk of Middle East war puts Iran’s quiet oil comeback in the spotlight
“The bottom line is that revisions and forecasts are weak, indicating ongoing concerns about the economy and reflecting some election year seasonality,” said Dennis DeBusschere of 22V Research. “This helps make earnings season another uncertainty-removing event.”
To make matters worse, large institutional investors currently have low purchasing power and seasonal market trends are weak.
Positioning in trend-following systematic funds is now tilted to the downside, and positioning in the options market shows that traders may be unwilling to buy on declines. Commodity trading advisors (CTAs) are expected to sell US stocks even if the market is flat next month, according to data from Goldman Sachs Group Inc. and volatility control funds that buy stocks when volatility falls are running out of room to increase their exposure.
History also seems to be on the side of the pessimists. Since 1945, when the S&P 500 rose 20% in the first nine months of the year, it has declined in October 70% of the time, data compiled by Bespoke Investment Research show. The index was up 21% this year through September.
Rod lowered
Still, there is reason for optimism, particularly the lower bar for earnings forecasts, which gives companies more room to beat expectations.
“The estimates were a little too optimistic and now they are falling back to a more realistic level,” said Ellen Hazen, chief market strategist at FLPutnam Investment Management. “It will definitely be easier to beat earnings because estimates are lower now.”
In fact, there is plenty of data to suggest that U.S. companies remain fundamentally resilient. A strengthening earnings cycle is likely to continue to offset stubbornly weak economic signals and tip the balance for stocks in a positive direction, according to Bloomberg Intelligence. Even struggling small-cap stocks that have underperformed their large-cap peers this year should see improving margins, BI’s Michael Casper wrote.
Fridays Job reportwhich showed an unexpected decline in the unemployment rate, allayed some concerns about a weak labor market.
Another factor is the Fed’s easing cycle, which has been a boon for US stocks in the past. Since 1971, the S&P 500 has returned 15% annually during periods when the central bank cut interest rates, data compiled by Bloomberg Intelligence show.
These increases were even stronger when interest rate cutting cycles began during non-recession periods. In these cases, large caps achieved an average annual return of 25%, compared to 11% during a recession, while small caps gained 20% during non-recession periods, compared to 17% during a recession.
“Unless earnings become a major disappointment, I think the Fed will have a greater impact on markets through the end of the year simply because earnings have been fairly consistent,” said Tom Essaye, founder and president of Sevens Report Research. “Investors assume it will stay that way.”