Earnings bar lowered as Q2 reporting begins amid evaporation of stimulus

Wall Street analysts continue to significantly lower the earnings bar as we enter the Q2 reporting period. Even as analysts lower the earnings bar, the stock has rallied sharply over the past few months.

As we have discussed before, it will not be surprising if we see a high percentage of companies “defeat” Wall Street Estimates. Of course, the high beat rate is always the same due to the sharp downward revisions to analyst estimates at the beginning of the reporting period. The chart below shows the change in Q2 earnings since the analysts first reported their estimates in March 2023. Analysts have lowered estimates over the past 30 days, lowering estimates by about $5/share.

That’s why we call it “Millennial Earnings Season.” Wall Street has been steadily lowering estimates as the reporting period approaches so that “everyone gets a trophy.” An easy way to see this is the number of companies that beat estimates every quarter, regardless of economic and financial conditions. Since 2000, about 70% of companies have consistently beaten estimates by 5%, but since 2017, that average has risen to about 75%. Again, that’s “beat frequency” would have been significantly lower if investors had kept analysts’ estimates at the original level.

Analysts remain bullish on earnings, even with weakening economic growth, persistently high inflation, and a drop in liquidity. However, despite a drop in second-quarter earnings estimates, analysts still see the first quarter of 2023 as the lowest point of earnings declines. Again, this is despite the Fed raising interest rates and tightening bank lending standards, which will work to slow economic growth.

However, between March and June of this year, analysts lowered expectations for 2025 by about $9 per share.

However, even if the earnings bar is lowered, earnings estimates still do not reflect the long-term growth trend.

As mentioned earlier, economic growth, from which companies derive revenues and profits, must also increase significantly for profits to grow at the expected pace.

Since 1947, earnings per share have increased by 7.72% while the economy has grown at 6.35% per year. This close relationship between growth rates is logical given the significant role of consumer spending in the GDP equation. However, while average nominal share prices rose by 9.35% (including dividends), a return to basic economic growth will eventually occur. This is because corporate profits are a function of consumer spending, corporate investment, imports and exports. The same applies to corporate earnings, where stock prices have fluctuated significantly.

This is important for investors due to the upcoming impact on “valuations.”

Given the current economic assessments from Wall Street and the Federal Reserve, high growth rates are unlikely. The data also suggests that reversion to the mean is entirely possible.

Back to the mean

After the pandemic-induced monetary policy surge and economic shutdown, the economy is slowly returning to normal. Of course, normal may seem very different from the economic activity we have witnessed over the past few years. Numerous factors at play support the idea of ​​weaker economic growth rates and, consequently, weaker earnings over the next few years.

1. The economy is returning to a slow-growth environment, with risks of recession.
2. Inflation is falling, which means less ability for companies to set prices.
3. Lack of artificial incentives to support demand.
4. Over the last three years, growth in consumption will have an impact on future demand.
5. Interest rates remain much higher, affecting consumption.
6. Consumers have significantly reduced savings and taken on greater debt.
7. Previous periods of dry stocks are now surpluses.

It should be noted that the reversal of this activity will be deepened by “vacuum” made by .

“We noted earlier the inherent problem with ongoing monetary interventions. Interestingly, fiscal policy implemented in the wake of the pandemic-induced economic shutdown has resulted in increased demand and unprecedented corporate profits.”

As shown below, M2 money supply growth has come to an end. Without further stimulus, economic growth will return to more sustainable and lower levels.

Although the media often reports that “stocks are not the economy” as noted, economic activity creates corporate revenues and profits. As such, stocks cannot grow faster than the economy for long. There is a decent correlation between the expansion and contraction of M2 minus GDP growth (measure of excess liquidity) and annual rate of change in . The deviation now appears unsustainable. More importantly, the current annual percentage change in the S&P 500 is approaching levels that preceded the reversal of that growth rate.

So either the S&P 500’s annualized return will decline as the market sells off on lower-than-expected earnings growth rates, or the liquidity ratio will rise sharply soon.

Valuations remain a risk

The problem with Wall Street consistently lowering the earnings bar by lowering future estimates should be obvious. Given that Wall Street touts future earnings estimates, investors are overpaying for investments. As should be obvious, overpaying for an investment today leads to lower future returns.

Even with the earnings decline from the peak, valuations remain historically high on both a one-year and forward basis. (Note the significant discrepancies in valuations during recessions, as adjusted earnings do NOT reflect what happens to actual earnings.)

Most companies report “operating” profits that obscure profitability by excluding all “evil things.” There is a significant discrepancy between the activities (or customized) and GAAP earnings. When there is such a big difference, you have to question “quality” these earnings.

The chart below uses GAAP earnings. If we assume current earnings are correct, the market is trading above 27x earnings. (This valuation level remains near previous bull market valuation peaks.)

With markets already trading well above historical valuation ranges, this suggests that results are unlikely to be as “bullish” as many currently expect. This is especially the case in the absence of more monetary support from the Federal Reserve and the Government.

Trojan horses

As always, we hope that Q2 earnings and full year reports will increase, justifying the market revaluation. However, as profits rise, markets rise too.

Most importantly, analysts have a long and ugly history of being overly optimistic about growth expectations that fall short. That is especially true today. Much of the economic growth and earnings were not organic. Instead, they were the result of a flood of stimulus into the economy that is now evaporating.

Overpaying for assets has never been a good thing for investors. As the Federal Reserve looks to slow economic growth to tame inflation, it makes sense that yields will fall. If they do, prices will have to adjust to lower yields by lowering their current valuation multiples.

When it comes to analyst estimates, always be cautious “Greeks Bearing Gifts.”