What Q4 Earnings Teach About How Markets Work

With 99% of S&P 500 companies reporting, Q4 2022 earnings season is pretty much wrapped—and to many, the results are thoroughly uninspiring. Earnings fell -4.6% y/y, with 6 of 11 sectors in the red.^[i] Never mind that revenues rose 5.3% y/y with only 2 sectors negative—the earnings decline stole the show.^[ii] We think it is pretty noteworthy, too, but not for the reasons most say.

The conventional take on dreary earnings is that analysts weren’t sufficiently pessimistic for Q4, which will trigger them to cut estimates further and send stocks on another trip lower. The theory about further downgrades may prove correct. We have often found that professional earnings forecasters tend to take the longest to shift their opinion. That isn’t a judgment, mind you, just an observation that we think has roots in basic human psychology. But we also don’t think this is the big market driver many purport. Arguing that analysts’ slashing earnings estimates will hit stocks anew is basically saying that stocks haven’t yet priced in earnings weakness. But to us, recent returns tell another story.

For one, the S&P 500’s 2022 bear market—which, to date, entailed a -24.5% decline between last January 3 and October 12—preceded the earnings drop.^[iii] That is pretty standard, as stocks usually move ahead of earnings trends. The 2000 – 2002, 2007 – 2009 and 2020 bear markets began before the earnings drops became official. In 2000, earnings per share didn’t start declining until Q4, months after the bear market that accompanied the dot-com bust began in late March. During the bear market that accompanied the global financial crisis from October 2007 – March 2009, earnings per share started falling in Q4 2007, but that didn’t become apparent until earnings season unfolded throughout Q1 2008. Ditto for 2020, when the lockdown-induced bear market began in February, before Q1’s earnings drop was in the books.

Crucially, that bear market also ended before earnings finished falling. S&P 500 earnings remained negative year-over-year through Q3 2020—the bear market had ended on March 23. In 2009, the bear market ended on March 9, but earnings kept falling through Q3. The exception here is the 2000 – 2002 bear market, which ended after earnings per share resumed growing, but we think that is because that bear market’s last downturn was stocks’ pricing in the downstream consequences of Sarbanes-Oxley. In our view, that was a late-bear market wallop that swamped stocks’ efforts to price a nascent earnings rebound—not analogous to today’s bearish earnings views.

Q4 2022’s sector earnings breakdown provides another way to see markets’ forward-looking powers at work. The biggest earnings decliners? Communication Services (specifically its economically sensitive Interactive Media & Services and Entertainment industries), Consumer Discretionary and Materials. Tech also endured a sizable drop. But Communication Services, Consumer Discretionary and Tech were the three worst-performing sectors during the bear market. Materials outperformed the S&P 500 slightly on a cumulative basis during the bear market, but that leadership concentrated in the market’s early reaction to Russia’s invasion of Ukraine. When commodity shortage fears proved false and commodity prices’ spike reversed, Materials suffered, and the sector underperformed by a wide margin from early June through the most recent low. So in all four cases, we think it is fair to say markets pre-priced falling earnings.

Meanwhile, Energy earnings boomed in Q4, rising 57.1% y/y—seemingly confirming what Energy stocks were pricing in as they soared last year.^[iv] Earnings also rose in the less economically sensitive Consumer Staples and Utilities sectors, which outperformed during the bear market. That suggests to us that stocks correctly anticipated their earnings would hold up relatively well as some economic indicators weakened. This is typical for these sectors, and it is why many call them “defensive” stocks.

Given this mountain of evidence that stocks moved ahead of Q4 earnings, we don’t think it makes sense to argue those same earnings will influence returns from here. Stocks look forward, not backward, and we think they price the probable future 3 – 30 months ahead. If the upturn since October indeed proves to be a new bull market, its sector returns will be emblematic of one, with many of the categories that got hit hardest on the way down enjoying the strongest rebounds. That is certainly true of Tech, which fell -33.3% in the downturn but is up 20.1% since October’s most recent low despite those disappointing earnings.^[v]

We aren’t dismissing the possibility of more downside from here. But if it happens, we don’t think it will be for the reasons everyone says—potential recession and earnings weakness are too widely known. We think stocks spent most of last year pricing those concerns in, alongside inflation fears, rate hike jitters, geopolitical uncertainty and the host of other fears that weighed on sentiment. Citing them as negatives now seems part and parcel of the “pessimism of disbelief” that Fisher Investments Founder and Executive Chairman Ken Fisher has long observed during new bull markets and just discussed in his latest New York Post column. We suggest embracing that negative chatter and seeing it as part of bull markets’ foundational pessimism, not as reason to dismiss the rally.