Between inflation, rising interest rates and a persistent bear market, investors have a lot to contend with. But there’s something else on their list of worries now, too: corporate earnings forecasts.
Stocks soared on the back of a better-than-expected inflation report last week, but experts agree that there’s more volatility ahead, especially given the concerns around a potential recession next year.
Complicating the picture is the fact that public companies could be headed for a tougher 2023 than analysts are predicting — and that’s bad news for stocks.
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Earnings reports are a window into economic health
Every quarter, publicly traded companies are required to release information about their performance. These companies all report basic stats about how their businesses did over the last three months, like revenue, but they also include data that is specific to them. For example, subscriber growth is an important metric for Netflix, while Apple might include information about new product sales.
These reports are intended to help investors get a sense of a company’s financial health and make informed decisions about their investments, explains Gargi Chaudhuri, head of BlackRock’s iShares investment strategy in the Americas. Quarterly earnings reports are a “window into a company’s expenses, debt, income and profitability,” she adds.
Earnings reports are also an opportunity for companies to look ahead, and to let investors know whether they’re expecting higher profits or slowing growth, Chaudhuri says. Analysts formulate predictions for corporate earnings before the companies release their reports, and those predictions get baked into stock prices.
But it’s “not the actual earnings figures” that move stock prices, Chaudhuri says. Instead, those prices move when a company’s actual earnings differ from what analysts were expecting. A recent Morningstar analysis found that companies that missed their earnings expectations in the third quarter saw their stock prices drop an average of 2.5% immediately.
Corporate earnings are also a window into the overall health of the economy. When consumers are spending and the economy is doing well, companies tend to earn more. A poor economic climate — think rising costs and economic uncertainty — means a company may earn less than expected.
In the third quarter of this year, companies generally performed better than expected. As of the beginning of November, when 429 of the 500 companies in the S&P 500 index had reported their results, 57% of that group beat analysts’ earnings per share expectations, according to Bank of America. That’s despite persistent inflation and the looming threat of recession. The trend has continued this week, with major companies like Home Depot and Walmart beating analyst expectations.
But experts say 2023 could be a different story.
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2023 earnings estimates may be too high
The crux of the issue is a possible disconnect between analysts’ published expectations for next year’s corporate earnings and how those companies actually end up performing.
If most investors are operating under the assumption that earnings will be higher than they actually turn out to be, that could spell major losses for stocks. “Larger surprises tend to create larger share reactions,” Chaudhuri explains.
It’s not yet clear how much expectations need to come down to minimize market surprises next year.
“The tough part is figuring out how far estimates need to fall and how much of a headwind that haircut will be for stocks as they try to dig their way out of this bear market,” LPL Financial chief equity strategist Jeffrey Buchbinder wrote last month.
Analysts have been making adjustment. A recent report from Bank of America found that estimates for 2023 have been cut three times as much as usual. But it’s possible those adjustments aren’t enough.
In a market update Monday, Morgan Stanley chief U.S. equity strategist Michael Wilson said he believes earnings estimates for 2023 are still higher than they should be. The consequence? “The bear market will likely resume once this rally is finished,” Wilson said.
Wilson expects the S&P 500 to bottom out roughly 17% lower than today’s levels in the first quarter of next year, and U.S. corporate profits to fall 11% over the course of 2023, Bloomberg reported.
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