US earnings need a boost for 2023 stock rally.

By Lewis Krauskopf

NEW‍ YORK (Reuters) ⁢- Stock ‌investors have been satisfied by middling U.S. corporate results so far this year but they‌ might not be so easy to please for the rest of 2023.

As the second-quarter earnings season winds down, ‍S&P 500 results are presenting a mixed picture, with companies beating analysts’ profit expectations at the highest rate in nearly two years even as revenue beats dropped to the lowest since early‍ 2020.

Investors appear content⁢ with that, ‍for now. The S&P 500 has edged higher since earnings season began in July, with the ‌benchmark index up 16% in 2023. But expectations call for corporate profits to pick up as⁤ the U.S. economy ⁢has so far defied recession fears, and investors may be far less⁢ forgiving if companies fail to​ deliver later this year, given the jump in equity valuations.

“Markets are ​expecting earnings⁢ to … deliver above and beyond where they have been,” said Eric Freedman, chief investment ​officer at U.S.‌ Bank Asset Management. “This is a market that has moved up in anticipation of earnings that we have not quite gotten yet.”

Overall, ⁤second-quarter⁢ earnings are⁤ expected to have fallen 3.8% from a year earlier, Refinitiv IBES ⁣data showed. ⁢That decline follows a 0.1% rise in the first⁣ quarter and a 3.2% drop ‍in the fourth quarter of last year.

Results are expected to improve, ‍however. Third-quarter S&P 500 earnings are seen rising 1.3% on​ a year-over-year basis, according to Refinitiv, before⁤ a 9.7%⁤ fourth-quarter earnings ⁣rise and a 11.9% full-year ‌increase in ​2024.

Meanwhile, the S&P 500 has become more richly valued. The⁤ index ​was trading ‌at 19.1 ⁣times forward 12-month earnings estimates as of Thursday, compared to its long-term average of 15.6​ times, according to⁣ Refinitiv Datastream. The P/E ratio ended 2022 at just below 17 times.

This year’s‌ valuation expansion accounted for 86% of the S&P 500’s year-to-date return through July,​ with the rest of the market’s boost coming ⁣from positive changes to earnings estimates,‍ an analysis by Credit Suisse equity strategists showed.

“At this point, ‍valuations have run ahead of the⁢ fundamentals‍ and so companies now have ⁤to prove that they can generate earnings growth,” said Anthony Saglimbene, chief ‌market strategist at Ameriprise Financial.

Q2 RESULTS

With 91% of S&P 500 ​companies having reported second-quarter results, 78.7% posted earnings above analysts’ ⁣expectations, ‌according to ​Refinitiv IBES. In aggregate, companies are reporting earnings‌ 7.7% above⁣ expectations, up from a long-term average of 4.1% above estimates.‍ Both the beat rate and surprise‌ factor are coming in at their highest rates since the third quarter of ⁢2021.

However,​ for revenue, only 62.9% of companies have topped‌ expectations – the ⁣lowest beat rate since the first quarter of ‌2020.

Stock⁢ reaction to earnings results has also ‌been ‍tepid, with share prices posting ⁣weaker responses to both beats and misses than ⁢the average over the past five years, analyst Julian Emanuel of Evercore ISI said. The average ⁤stock fell 0.6% after⁤ results in the second quarter, Emanuel said in a note⁢ on‌ Thursday.

“We went⁤ from a market that is saying, ‘Earnings had to back it ​up’ to ‘Thankfully earnings didn’t screw⁤ this up,’” said John Lynch, chief investment ​officer for Comerica Wealth Management. ​“That just gets ⁢us into a more expensive realm.”

Meanwhile, there have ‌also been some high profile disappointments, with Apple shares dropping 4.8% after the iPhone​ maker’s ⁢weak⁤ sales forecast. Other megacap companies, such as Amazon and Alphabet, have seen a ‍positive‌ investor response to their reports.

Companies reporting results next week include key retailers, ⁣such as Walmart and Home ⁢Depot, while the release of monthly retail​ sales on Tuesday also could influence markets.

While investors generally have turned more positive about the⁤ economic outlook, some still are wary of a ‍recession stemming from the delayed impact of higher interest rates, as⁣ indicators such as the Treasury‌ yield ⁢curve are still flashing warning signs.​ ​ ⁣Such a downturn ⁣could severely change ​the prospects for ⁣corporate earnings and potentially⁤ weigh on valuations. During recessions, earnings fall at a 24% annual rate on⁢ average, according to Ned Davis Research. ‍“There is optimism,‌ but I still wonder going into next year, are we too optimistic, from ⁣a consensus standpoint,” said Comerica’s Lynch. “Just because we didn’t have a⁤ recession ‌this year, that ⁢yield curve continues to point to one.”

(Reporting by Lewis Krauskopf; Editing by Ira ‌Iosebashvili and Richard Chang)

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