On America’s Earnings Upturn

Every now and then, markets move so fast that if you blink, you miss it. Case in point: Since its correction low (to date) on October 27, the S&P 500 is up 6.4%, erasing more than half its decline since July 31’s year-to-date high.^[i] Maybe the recovery is here, or maybe it is a false dawn before negative sentiment strikes back—short-term moves are always impossible to predict. Yet eventually investors’ emotions will be spent. Markets should then resume weighing fundamentals over the next 3 – 30 months relative to expectations—and on that front, there is more evidence the landscape looks bright. Case in point: S&P 500 earnings resumed growing in Q3, faster than analysts projected and showing the bull market that got underway in October 2022 wasn’t a mirage.

Through Q2, S&P 500 earnings had fallen three straight quarters on a year-over-year basis. Not every sector endured a negative threepeat, but the declines were broad enough to fuel lots of “earnings recession” chatter and arguably justify last year’s bear market. Stocks pre-priced the drop, as they usually do, and once they had registered the extent of the likely damage, they shifted their horizon further out and began looking toward the recovery, moving up before earnings did.

This created the typical early bull market backdrop of rising markets alongside falling earnings—to many, a contradiction. Just about every time this happens, it fuels a chorus of pundits arguing the market is wrong and stocks have gotten too far out over their skis, setting up trouble for overvalued markets once reality sets in. We suspect this seeming disconnect is partly why the decline that began in July touched so many nerves. We thought from the start that it was most likely a correction—a sharp, sentiment-fueled drop of -10% to -20%—and economic fundamentals seemed to agree, with most indicators pointing positively. But as earnings season got underway in October, consensus estimates said S&P 500 profitability would remain elusive, with another small decline the baseline forecast.

But results surprised to the upside. With nearly 85% of companies reporting so far, blended S&P 500 earnings (which aggregate the 426 reporting companies with estimates for the remainder) are up 4.1% y/y.^[ii] Even that positive headline figure doesn’t quite capture how good the results were, as there was base-effect skew from big drops in Energy and Materials, which surprised no one considering the year-over-year reference point included last year’s big run up in oil, natural gas and other commodity prices. Aside from them, only Health Care was negative, and five sectors (Communication Services, Consumer Discretionary, Financials, Tech and Utilities) grew double digits. Communication Services and Discretionary soared more than 40% y/y.

Revenue growth was also positive and broad-based, though slower than Q2 at 2.1% y/y.^[iii] Here, Energy, Materials and Utilities were negative. This shows you Health Care’s earnings decline stemmed more from cost pressures than top-line weakness, while Utilities’ falling sales and rising profits likely stem largely from falling oil and other energy commodity prices, which are a key input. Elsewhere, revenue growth mostly trailed earnings growth, showing Corporate America is at last overcoming the cost increases that hampered profitability—and signaling that the inflation bulge has mostly worked its way through the system.

Exhibit 1: S&P 500 Earnings and Revenues at a Glance

Source: FactSet, as of 11/7/2023. S&P 500 blended earnings and revenue growth, Q3 2023.

We present this with the usual caveat that these earnings figures are backward-looking. They reflect what happened between June and September, and we think stocks already priced it in. However, this also looks to be a mere down payment on more earnings growth to come. Analysts expect growth to continue in Q4, coming in strong enough to lift full-year results into the black. Projections for 2024 are also positive.

Those forecasts could be wrong, of course. But given 81% of companies reporting thus far beat expectations in Q3—more than average—and that analysts’ forecasts usually understate actual growth, we think it is likelier than not that analysts have underestimated as usual, laying the groundwork for positive surprise—the kind of positive surprise that propels stocks up the bull market’s wall of worry.