More than half of the companies in the S&P 500 have already reported their quarterly results, and everything has gone surprisingly well. It's true that they have been battling record-high inflation and constant rises in interest rates. But there have also been some reasons for investors to feel optimistic, hence the sudden rebound in stock investment. So let's take a look at the good news from this earnings season, the caveats to keep in mind, and where stock investing stands in the future...
Why are investors so optimistic?
Revenue and profits grew in most sectors
The S&P 500 has seen global revenue and profits grow 16% and 9%, respectively, compared to the same period last year, indicating that companies have weathered a difficult environment quite well. And although investment in shares of the energy sector (who have benefited from the rise in energy prices) has been the biggest driver of these figures, it is not the only one: the income of all sectors has grown, and the profits of 7 sectors have increased. In fact, even if we exclude the good results of the energy sector, the income of American companies continues to grow.
Investment in shares has seen its income and profits grow. Source: Morgan Stanley
The results were not as bad as expected
Investors tend to focus less on raw numbers and more on how those numbers compare to what the market expected. The result of the second quarter so far is clear. Investing in stocks has done better than analysts thought. In fact, you can see below that 52% of companies have significantly beaten estimates, while only 12% have had significant negative surprises.
S&P second quarter results. Source: Goldman Sachs
Companies continue to invest in growth
Companies' capital expenditures (capex) are often a good way to gauge how concerned companies are about the future. And according Goldman Sachs, companies have collectively increased their capex plans since the start of earnings season. This suggests they are confident that any setbacks in growth are only temporary, and that better economic conditions will return soon.
What problems can we face?
There are signs of trouble beneath the surface️
If earnings updates have come in above expectations, it's partly because analysts had already lowered those expectations considerably. And while most companies also significantly beat their own estimates, they do so almost every quarter. It is common practice to under-promise and over-deliver. We've even seen a decline: 52% of companies, on average, have beaten estimates this earnings season, compared to 62% in the previous four quarters. In fact, if we look back at the chart above, we will see that this quarter's results are generally worse than the previous four. And those figures are not even adjusted for inflation...
The economic environment could go from bad to worse️
Although inflation and interest rate increases have created a difficult economic environment in the second quarter, things are likely to get even more complicated in the third and fourth quarters. This is because the massive increase in interest rates by the Federal Reserve will take time to impact the economy, restricting and cooling economic activity. And if the economy contracts, this will take its toll on American companies: corporate profits have fallen an average of 13% in previous recessions.
The Fed's interest rate hikes have altered the path of stock investing. Source: Morgan Stanley
Investors may be too optimistic
Investors may have lowered their expectations, but they remain optimistic. They predict that profits will grow by 6,7% in the third quarter, 6,7% in the fourth and 8,9% in 2022 as a whole. This is despite the fact that the "breadth of the review of the Earnings” (a net count of the number of upgrades to analyst estimates) have already started to decline. That's not a good sign because a decreasing amplitude (blue line) usually tells us that the next 12 months of earnings growth will fall (yellow line). If this pattern holds this year, there is a chance that companies will decide to eliminate all their bad news at once to prepare for a better 2023. That could accelerate the decline.
The decline in the breadth of earnings revisions typically precedes the decline in EPS growth estimates. Source: Morgan Stanley
So where will equity investing go next?
The deterioration of the economic environment will make it difficult to maintain these returns in the next two years. And if earnings are much lower than expected in upcoming updates, this can dampen investor sentiment and drive the value of the stock investment down. In other words, the downside risks are greater than the upside potential, especially given the optimistic expectations of investors. So if you have come here looking for a signal to buy the dip, we are sorry to disappoint you but now is not the time appropriate. The fact is that we are either going to see prices and earnings expectations fall to a level that truly reflects the risk of a prolonged recession, or we wait for evidence that companies can handle a worse environment. . We're not seeing either yet. In the meantime, you're probably going to want to maintain a diversified and robust portfolio, built to withstand almost any environment, like this one. If that means losing profits by being conservative with our stock investment when markets rise, it's not a big deal. There are times when you have to take risks, and times when you have to be cautious and limit your losses. Right now, the best option would be to be cautious.