As the third-quarter earnings season kicks off, analysts are expecting solid numbers from S&P 500 companies, but not enough to spark a significant stock market rally.
PepsiCo will lead the reporting season on Tuesday, followed by financial heavyweights JPMorgan Chase and Wells Fargo on Friday.
According to FactSet, third-quarter earnings per share for the S&P 500 companies are projected to grow by 4.1% year-over-year, amounting to just over $60.
This rise is expected to come on the back of 4.7% sales growth, which seems reasonable considering that both economic growth and inflation have slowed down to low-single-digit levels.
Rising costs keeping margins in check
While companies have managed to keep product costs relatively stable, other expenses, such as wages and employee benefits, continue to rise.
These increasing operational costs are squeezing profit margins, preventing them from expanding as much as businesses might hope.
The fastest-growing sector remains technology, with companies like Nvidia and Microsoft leading the charge.
Nvidia is benefiting from the growing demand for its AI chips, which are critical to powering AI-enhanced cloud services.
Similarly, Microsoft is capitalizing on its AI cloud offerings, with businesses willing to pay a premium for cost-saving solutions.
Meta Platforms is also seeing gains, using AI to boost user engagement and ad revenue.
Cyclical sectors dragging overall earnings
While tech companies are thriving, other sectors are holding back the S&P 500’s overall earnings growth.
Economically sensitive or cyclical sectors such as financials, consumer discretionary, and industrials are expected to post year-over-year earnings declines.
Materials and energy sectors are also facing headwinds, with oil prices currently lower than they were in the third quarter of last year.
Evercore analysts highlight these sectors as the primary drag on the index’s earnings growth.
Sluggish sales in these mature industries, which fluctuate in response to broader economic conditions, are contributing to the subdued outlook.
Earnings beats are likely, but don’t expect a surge
The good news? Companies are still likely to exceed analysts’ earnings estimates.
Historically, corporations tend to beat quarterly projections by a few percentage points.
This trend has been consistent since the financial crisis, and most recently, during the pandemic recovery period in 2021, the index saw earnings beats of more than 20%.
However, such massive earnings surprises have since tapered off, with Wall Street now having a clearer picture of the economy and corporate profitability.
Even though earnings beats are expected, they likely won’t move stocks much higher.
The S&P 500 has already gained roughly 20% so far this year, reflecting a moderately growing economy, lower inflation, and the Federal Reserve’s efforts to maintain growth.
Every sector in the S&P 500 is up year-to-date, but the rally has pushed the index’s price-to-earnings (P/E) ratio to over 21 times forward earnings.
That’s at the higher end of its recent range, making stocks look relatively expensive.
High valuations limit market potential
If companies offer optimistic earnings forecasts or raise guidance, their stocks could see modest gains.
However, with the current P/E multiple already elevated, even a small upward revision in earnings expectations won’t do much to move the market.
For example, if expected earnings per share for the S&P 500 over the next four quarters increase by 3%, reaching $272 from the current $265, the index would still trade at a lofty 21 times earnings, leaving little room for stocks to appreciate further.
Valuations are already stretched, and there’s minimal tolerance for companies missing expectations or providing cautious outlooks.
As Citi strategist Scott Chronert puts it,
Beats and smaller-than-normal revisions support our earnings resilience thesis, but what has changed is valuations. There is less room for fundamental missteps.
In summary, while American companies are performing well, with earnings likely to surpass expectations, this isn’t enough to push the stock market significantly higher in the short term.
The rally that has already lifted the S&P 500 by 20% this year has pushed valuations to a level where further gains are hard to justify, unless there is a substantial and sustained improvement in earnings or economic conditions.
For now, the market appears to be in a holding pattern, with limited upside as we move through the third-quarter earnings season.
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