The bear market for U.S. stocks risks dropping even further if the third-quarter earnings season falls short of optimistic outlooks.
S&P Global Market Intelligence economists forecast that S&P 500 earnings per share will decline in 2022 and grow modestly in 2023, with an expectation of earnings per share of $47.33 in the third quarter. This is well short of the consensus estimate of $55.75 and more pessimistic than the consensus view of broadly unchanged full-year earnings for 2022 and faster growth in 2023.
"If that's what's priced in, then the market is overvalued," said Joel Prakken, vice president, chief U.S. economist and co-head of U.S. economics at S&P Global Market Intelligence.
The S&P 500 has already sunk more than 20% in 2022 as rising interest rates increase the discount rate investors use to value stocks, particularly the tech stocks that built historically high valuations during the era of low rates.
The price-to-earnings ratio — a closely watched valuation metric — has fallen back to 19 from over 30 in late 2020 as markets priced in the effect of the yield curve with significant reevaluations for stocks such as Tesla Inc. and Netflix Inc., which blew up as money sloshed through financial markets.
If earnings fall short of consensus expectations, valuations would become more stretched unless stock prices fall further.
"A worse-than-expected season would likely cause a further sell-off since equity markets have not priced in a significant deterioration in the demand outlook," said Anik Sen, global head of equities and a portfolio manager at PineBridge Investments.
Stocks and bonds
The S&P 500 gained 113% between March 23, 2020, and Jan. 1, 2022, in a tremendous run fueled by low interest rates and asset purchases by the Federal Reserve. A reversal of those monetary policies drove the subsequent collapse of the index.
With rampant inflation rather than financial stability now the key concern, the Federal Reserve is tipped to continue raising rates from a current range of 3%-3.25% to at least 4.5%-4.75% by June 2023.
Rising interest rates force the price of bonds such as Treasurys lower, raising the yield of the accompanying coupon and making them more attractive for investors. That draws capital away from stocks.
Persistent inflation is also worsening the economic outlook.
"We were already of the opinion that analysts' expectations for earnings were too rosy, even if the economy bent rather than broke. But we are now forecasting a worse outlook for both U.S. and global growth," John Higgins, chief market economist at Capital Economics wrote in a Sept. 28 note.
Priced in
Others are more bullish that economic negativity and weaker earnings have already been priced in for equities.
"Having seen some demand weakness creep [into] second-quarter earnings, our channel checks and company meetings do not suggest things have got materially worse in most verticals," said Mark Sherlock, head of U.S. equities at Federated Hermes Ltd. Sherlock expects consensus estimates to be met, "for this quarter at least."
"The legendary U.S consumer continues to surprise, potentially assisted by lower prices at the petrol pump," said William Marsters, senior sales trader at Saxo UK.
Still, the continued strength of consumers is questionable as inflation eats into real income and the economy shrinks.
"We think, as usual, companies have guided expectations for the third quarter to such a level that the majority of them will be able to meet or exceed expectations," said Joachim Klement, a strategist at investment bank Liberum. "The really interesting development to watch will be how analysts react to guidance for the fourth quarter and the next 12 months."
Analysts will likely downgrade earnings expectations, while stocks will continue to fall, Klement said.
"Analyst earnings growth expectations are too optimistic for what looks like an earnings recession ahead," Klement said.