The Big Picture
Your ears don't deceive you and neither will your eyes in due course. Hard as it might be to believe with the fourth quarter earnings reporting season wrapping up not that long ago, the coming week will feature the start of the first quarter earnings reporting period.
It will be a relatively slow start, but the reporting cadence will pick up starting in the third week of April and continuing until mid-May. By then, market participants will have a good line on the results for the March quarter and how companies expect the coming months to unfold for the economy and their earnings prospects.
Here we are reminded that the stock market is not the economy; however, economic activity drives earnings, and earnings (and earnings expectations) drive the stock market. There is no escaping that, which is why every earnings reporting period starts with an inhale and typically (but not always) ends with an exhale.
An Uncommon Development
The fourth quarter reporting period warranted its share of breathing exercises. It didn't get off to a great start. When we penned our preview of that period in mid-January, the blended fourth quarter earnings growth rate (combines actual results with estimates for companies that have yet to report) was 0.4%. On January 26, it stood at -1.4% (inhale).
When the fourth quarter reporting period ended, the earnings growth rate had settled at 4.3% (exhale).
So, where does the first quarter blended earnings growth rate stand today? It is at 2.9%, according to FactSet. That is down from 5.8% on December 31.
It is not uncommon for the earnings growth rate estimate to be reduced ahead of the reporting period. What is uncommon about this reporting period is that analysts haven't reduced earnings estimates as much as they normally do.
According to FactSet, the median bottom-up estimate for the first quarter decreased by 2.5% between December 31 and March 27 versus an average decline of 3.7% over the past 20 quarters.
It is understandable why the estimate cuts haven't followed form with the historical average. The main reason is that the economy hasn't followed form with the history of a tightening cycle. It has continued to defy expectations that the impact of the so-called lag effect of prior rate hikes would hit more forcefully.
Remarkably, the economy has shown signs of strengthening. Real GDP increased 3.1% in the third quarter, 3.3% in the fourth quarter, and is projected in the Atlanta Fed GDPNow model to grow 2.5% in the first quarter. The overarching point is that there is no contraction evident in those figures, or any substantive slowdown, despite the Fed raising rates 11 times between March 2022 and July 2023.
Estimates Holding Up
We would venture to say, then, that there is optimism in front of the first quarter earnings reporting period. One could stake a claim on that assertion by pointing to the S&P 500 closing at a record high at the end of the first quarter while interest rates were going up.
The interest rate increase was a byproduct of the stronger-than-expected economic data, as well as some sticky inflation data that forced the market to rethink its outlook for Fed rate cuts.
In brief, the year began with an expectation for six cuts by the end of the year. The current expectation is that there will be three rate cuts by the end of the year. Market pricing, however, is entertaining the idea that there might only be two rate cuts, and, alternatively, there have been assertions from some Fed officials that there might be no rate cuts if progress on inflation stalls.
The good news is that there has been no stalling in the economy, which is why earnings estimates have held up as well as they have, not only for the first quarter, but for the calendar year and forward 12-month period as well.
The market has been excited by that and has arguably run ahead of the good earnings news embedded in consensus estimates. Hence, there has been multiple expansion, which is to say stock prices have seen a bigger percentage increase than earnings estimates have. To wit: the S&P 500 has surged 9.4% since the start of the year while the forward 12-month EPS estimate has increased by only 3.2%.
The Trend Has Been the Market's Friend
The earnings estimate trend, though, has remained the market's friend. With the market-cap weighted S&P 500 sporting a premium valuation, it is important that relationship stays on good terms.
So, in connection with the first quarter reporting period, the quantitative and qualitative guidance coming out of it will carry a lot of weight with respect to moving the market. Optimism is high, but so is the bar in terms of valuation.
Guidance disappointments will be dealt with prudently by the market, and, in some cases, quite rudely as the benefit of living up to higher growth expectations gets ripped away.
The attention to guidance will be most acute in the higher-growth pockets of the market, namely the information technology and communication services sectors, as well as in the cyclical corners of the market, namely the industrials, materials, and consumer discretionary sectors.
The banks do not tend to provide much in the way of specific earnings guidance, but their qualitative assessment of loan demand and loan quality, coupled with their provisions for loan losses, will offer some meaningful perspective on economic conditions.
Before the guidance, though, comes the actuals for the first quarter.
FactSet informs us that the projected earnings growth in the first quarter will be provided by the information technology (3.68 percentage points), communication services (1.67 percentage points), consumer discretionary (1.05 percentage points), utilities (0.64 percentage points), financials (0.13 percentage points), and real estate (0.13 percentage points) sectors.
The remaining five sectors are all expected to subtract from earnings growth. The energy sector (-2.31 percentage points) is estimated to be the biggest drag followed by health care (-1.16 percentage points).
What It All Means
That, of course, is how things stand today (inhale). These projections will all change in the ensuing weeks. Some will move up and some will move down. Presumably, if history is any guide, the final tabulation will result in first quarter earnings growth for the S&P 500 that is at least two percentage points higher than the 2.9% growth rate projected today (exhale).
If the stock market wants some breathing room, though, as it works its way through the second calendar quarter, then the guidance during the first quarter reporting period can't be a choking hazard. That would take the market's breath (and maybe its breadth) away.
