Earnings Growth Should Continue To Support The Stock Market
We are approaching peak earnings, but we aren’t there yet
Given we are entering earnings season, it seems as good a time as any to refresh some of the leading indicators for corporate earnings growth and their implications for the stock market.
Overall, the majority of my lead indicators for S&P 500 EPS growth remain relatively neutral over the coming six months. However, we are seeing signs EPS growth is likely to retreat at some point later this year or in early 2025. Consumer Confidence, the US dollar index and small business earnings trends are several lead indicators that look to be rolling over. No indicators however are pointing to any material decline in EPS growth over the next six months. We are approaching peak earnings, but we aren’t there yet.
In addition to the above dashboard, several other lead indicators of EPS growth are sending a similar message. Oil prices for one are pointing to short-term upside before a decline as we head into 2025.
The collapse in goods prices we have seen over the past 18 months have also constrained corporate revenue and thus earnings. Fortunately, the outlook for goods inflation does appear relatively positive from here. Although the extent to any goods price appreciation we see remains to be seen, this dynamic should be supportive from a revenue and earnings perspective for the rest of 2024.
Corporations have lost a lot of pricing power in recent times. Another indicator of this which points to a less supportive outlook for EPS growth is the NFIB Small Business Survey’s Percent of Participants Planning to Raise Prices component, which as we can see below is pointing to downward sales growth over the coming quarter. As such, corporate earnings could be set to slide modestly in Q3, something which consensus estimates are already suggesting.
Earnings revision breadth is also pointing to the potential for less robust EPS growth moving forward, though this is a very volatile data point and as such further negative readings are required to glean definitive conclusions for the time being.
One important component of corporate earnings and profit margins that appears much more supportive in the medium-term is wage growth. We can see the relationship between profit margins and wages below, given wages are a significant component of corporate expenses (though far less than was the case 30-40 years ago).
And, as I have discussed in great detail of late, the outlook for US wage growth remains firmly to the downside for at least the rest of 2024. While the relationship between earnings and wage growth is less robust, falling wages should at least be somewhat supportive of earnings growth in addition to being supportive of profit margins.
As always, it is very much worth highlighting the relationship between earnings growth and the business cycle. After all, almost all economic and asset price cyclicality can be tied to the business cycle in one way or another. Regular readers will know the lead indicators of the business cycle are pointing to a cyclical upturn over the coming nine to 12 months. A cyclical upswing should on net be supportive of corporate earnings.
In addition, the easing of monetary policy globally is another indicator supportive of positive EPS growth over the coming 12 months. Though it should be noted the lead time between changes in monetary policy and corporate earnings varies over time.
Putting these various indicators together, it seems likely earnings growth should trend sideways to slightly higher over the next two to three quarters on net. My composite EPS leading indicator is pointing to an earnings decline in Q3, then a rebound in Q4. Though the upside in earnings growth overall appears limited, this indicator does not yet suggest the downside is material.
My alternative EPS lead indicator (which comprises a smaller set of inputs than the composite above) is suggesting a similar outcome.
It is also worth pointing out Morgan Stanley’s various EPS lead indicators are pointing to a similar outcome.
As are my own EPS Nowcasts (though the latter do suggest a peak in late 2024/early 2024, as we can see below).
If we now turn our attention to what the S&P 500 is pricing in from an earnings perspective, it’s fairly clear any upside in EPS growth expected over the coming six to nine months has largely already been priced into the broad stock market indices.
The Nasdaq and S&P 500 are priced to perfection. Perfection breeds vulnerability. Thus, stocks appear exposed to the downside should earnings materially disappoint at any point in 2024, particularly when we consider just how extended the S&P 500 has become relative to actual underlying corporate earnings.
But, as we have seen, the lead indicators overall are not yet suggesting any material deceleration in earnings growth is likely from here, meaning it is probably unlikely we see a significant earnings driven sell-off. However, we must take caution given how much is already priced in by risk assets.
Overall, my stock market dashboard is relatively supportive of stocks from a economic, business cycle and monetary policy perspective over the medium-term. Stocks are very overbought versus underlying liquidity growth, but this condition has shown a tendency to remain for relatively long periods of time. It is again from a positioning perspective the upside for the overall market appears limited.
Indeed, almost all measures of stock market positioning are currently sending neutral to extreme readings. As we can see below, positioning is not the supportive factor for risk assets it was in 2023 or even earlier this year. Again, extremes in positioning create vulnerabilities should fundamentals (i.e. earnings) disappoint.
Does this mean stocks need to sell off? No. But it does limit the upside and probably suggests some kind of positioning unwind is likely over the short-term. For me to become really concerned about a sustained corrective period in stocks similar to what we saw in 2022, I would need to see earnings lead indicators roll over, business cycle lead indicators roll over, elevated positioning in addition to more of the below indicators of liquidity and financial conditions hit the red.
Short-term risks abound
But I say that to say this: there are plenty of short-term risks currently facing markets.
We have discussed the positioning and market pricing elements, and although the S&P 500 appears unlikely to have a broad earnings driven sell-off imminently (that appears more likely a story for 2025), plenty of short-term headwinds are now facing markets.
One is seasonality, as late July and August are generally two of the worst months for stocks. As we enter the post-July options expiration window of vulnerability, the S&P 500 is more susceptible to bearish flows, news and price action overall.
Some short-term growth risks are also seemingly present. While I am bullish the business cycle as discussed, the path is never linear and much of the positive growth outlook (if not all) has been priced in, leaving stocks vulnerable to bearish macro developments. One such indicator of this is my PMI Quadrant, which is currently sending a risk-off signal.
Similarly, ECRI’s Leading Economic Index has also diverged lower from stocks, again suggesting we could see downside surprises in growth over the short-term, which is the opposite of what stocks are pricing in.
In all, now is an important a time as ever for investors to keep their head on a swivel. Stocks have priced in a lot and had an excellent 18 months. While we probably don’t have any major fundamental catalysts for a bear market, there are short-term risks present, and an unwind in investor positioning seems the most likely scenario for me over the next two to three months.
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