First quarter earnings season is nearly complete, and it has caused us to regret titling our earnings preview commentary on April 10, “Malaise Continues.” While the “better than feared” label fit the past couple of earnings seasons quite well, based on the magnitude of upside surprises in the first quarter, and encouraging guidance from corporate America, that’s probably underselling it. There’s plenty to worry about the rest of the year (debt limit, recession, tightening financial conditions, a Federal Reserve (Fed) policy mistake, among them), but the risk of an additional sharp contraction in profit margins has come way down.
Corporate America faced several headwinds during the first quarter, including, most notably, lackluster economic growth, still-high inflation and related cost pressures, and stress in the banking system that caused financial conditions to tighten after the bank failures in March. Plus, S&P 500 companies were coming off a difficult fourth quarter in which earnings fell short of estimates. These factors led analysts to forecast a 6-7% year-over-year earnings decline in the first quarter, slightly worse than the roughly 5% decline in the fourth quarter of 2022. What we’ve gotten has been much better than that (Figure 1).
So what helped drive such a big upside surprise? We would point to these five factors:
These positive surprises contributed to an increase in the consensus 2023 earnings estimate during earnings season, offering a sign of stability that should cause some of the earnings bears—and there are many—to rein in some of their pessimism (Figure 3).
In a typical year, a solid earnings season relative to expectations would not trigger a reduction in earnings estimates. But this year is anything but typical. As the odds of recession have increased, the chances of a late-year earnings rebound have diminished. In other words, as we’ve signaled in recent commentaries, our estimate of flat earnings per share (EPS) for the S&P 500 in 2023 at around $220 looks a bit high.
We use the following scenarios to come up with an updated, probability weighted earnings forecast for 2023:
If we probability weight these, as shown in Figure 4, with a mild recession the highest probability, we end up with an S&P 500 earnings number in the $212–$214 range for 2023.
For 2024, given the likelihood that a late-2023 recession spills over into early next year, we’re taking our forecast for S&P 500 EPS down from $240 to $230, still an 8% increase from our downwardly revised 2023 estimate and consistent with the long-term average earnings growth rate for the index.
We make no change to our year-end S&P 500 fair value target range of 4,300–4,400, with the index currently just 4% below the low end of the range. Lower interest rates support higher stock valuations, so a price-to-earnings ratio (P/E) near 19 on $230 in S&P 500 EPS in 2024 looks reasonable. Recall the 10-year Treasury yield, near 3.40%, was about 0.6% higher in early March before Silicon Valley Bank failed.
At year end, we expect the inflation outlook to look much better, enabling market participants to look through the economic malaise and toward recovery in 2024—hopefully with the debt ceiling and regional bank issues fully put to rest.
Solid earnings results compared with expectations have helped keep stocks afloat in recent weeks amid debt ceiling jitters, regional bank concerns, and louder calls for recession. But we’re still in an earnings lull and a weak seasonal period for stocks. While a Fed pause is likely to arrive in June, gains may depend on the continued resilience of the U.S. economy. And the S&P 500 has had a very tough time breaking through the 4,200 chart resistance level, so we may be in for more choppiness from a technical perspective. Bottom line, while stocks may beat bonds over the rest of the year, we do not see a lot of upside.
The LPL Research Strategic and Tactical Asset Allocation Committee (STAAC) recommends a slight overweight allocation to equities, with a move back down to neutral in the near term currently under discussion. The STAAC has squared up its views on growth and value, favors large caps over small, and maintains the industrials sector as the top overall sector pick. From a pure technical analysis perspective, communication services and technology look increasingly constructive with building relative strength.
Within fixed income, the STAAC recommends an up-in-quality approach with a benchmark weight to duration. We think core bond sectors (U.S. Treasuries, Agency mortgage-backed securities (MBS), and short-maturity investment grade corporates) are currently more attractive than plus sectors (high-yield bonds and non-U.S. sectors) with the exception of preferred securities, which look attractive after having recently sold off due to the banking stresses.
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