The Big Picture
The fourth quarter earnings reporting period isn't over yet, but the end is in sight with only 110 or so S&P 500 companies yet to report. That's a nearly 80% completion rate and it can be said that the fourth quarter reporting period has unfolded much better than expected.
When we published our preview on January 10, the fourth quarter blended earnings growth rate stood at 11.7%. Today, according to FactSet, it stands at 16.9%, which is the highest year-over-year earnings growth rate since Q4 2021.
Analysts typically cut their estimates as a quarter carries on, thereby making it "easier" for companies to hurdle the lower bar. They did that this time too, but to be fair, the blended growth rate on September 30 stood at 14.3%, so this reporting period has truly been better than expected as opposed simply to better than the lowered estimate.
That's the good news.
The bad news is the strong earnings growth hasn't translated into a less expensive market.
Earnings Do the Driving
A market trading with a full, if not rich, valuation has a fuller and richer valuation as the fourth quarter reporting period moves into its final stages. That doesn't mean the market can't get fuller and richer on further multiple expansion. One can never know fully the extent to which momentum and animal spirits can take things.
It does suggest, ironically, that there will be a high price to pay if the fundamental ground on which the confident stock market stands is shaken.
There was a little taste of that this past week with the release of the January Consumer Price Index. That report caused a momentary rumble, yet the January Producer Price Index prevented a tectonic shift thanks to a component breakdown that suggested there might not be cause for undue inflation alarm when the January PCE Price Index is released on February 28.
That point aside, earnings are what drive the stock market, so if one wants to make a case for why the stock market has stood strong through the DeepSeek upset, the tariff uncertainty, and the CPI inflation scare, earnings would be the bedrock evidence.
The market cap-weighted S&P 500 is up 4.0% to begin the year and the equal-weighted S&P 500 is up 3.3%. Those moves are the nexus of multiple expansion considering that the forward 12-month EPS estimate has gone up only 0.6% since the start of the year. The calendar year 2025 estimate, meanwhile, has gone down 1.1% since the year began.
The earnings estimate trends bear close watching. If they don't start picking up with some better momentum of their own, particularly the forward 12-month estimate, then we may be staring at a market that has the unsatisfying disposition of "churning."
That is market parlance for "spinning its wheels" or not really getting anywhere. Just a lot of chop with some good days and some bad days, creating a feeling of going everywhere and nowhere all at once.
Looking for the Next Level
That is the pratfall of a market that trades with a full valuation in the case of the equal-weighted S&P 500 and a rich valuation in the case of the market cap-weighted S&P 500. It demands good news to hold its form, but it needs "next level" news to get into a sustainable breakout mode given the high valuation at which it now trades.
Some "next level" items would include:
- Inflation getting back to the 2.0% target without the economy tanking.
- A big step up in productivity aided by technological advances like AI.
- Passing tax cuts without increasing the deficit.
- A trade detente between the U.S. and China.
None of that will come easily, if at all, but even baby steps in any of these directions can go a long way toward lifting investors' spirits and earnings estimates.
What It All Means
We said the fourth quarter earnings reporting period would be an important tell for the market. It has told us that U.S. companies continue to exhibit earnings strength in the face of headwinds like the stronger dollar, geopolitical uncertainty, higher interest rates, and sticky inflation.
What it has also told us is that the bar of earnings expectations is rising. That is because companies have easily surpassed lowered estimates, but it also because the market's high valuation carries the command that earnings growth cannot disappoint, or the price-driven multiple expansion will turn into price-driven multiple compression.
