Earnings season preview: The S&P 500’s $8 trillion rally needs to be put to the test

The S&P 500 Index is up about 20% through 2024, increasing its market cap by more than $8 trillion. The gains are largely driven by expectations of monetary policy easing and a resilient earnings outlook.

But the tide could be turning as analysts lower their expectations for third-quarter results. Companies in the S&P 500 are expected to report a 4.7% increase in quarterly profits from a year ago, according to data from Bloomberg Intelligence. That’s down from forecasts of 7.9% on July 12, and would be the weakest increase in four quarters, BI data showed.

“Earnings season will be more important than usual this time around,” said Adam Parker, founder of Trivariate Research. “We need concrete data from companies.”

In particular, investors are eager to see whether companies are delaying spending, whether demand has slowed and whether customers are behaving differently due to geopolitical risks and macro uncertainty, Parker said. “Precisely because there is a lot going on in the world, corporate profits and guidance will be particularly important now,” he said.

Reports from major companies are coming in this week, with results from Delta Air Lines Inc. on Thursday and JPMorgan Chase & Co. and Wells Fargo & Co. on Friday.

“Earnings seasons are generally positive for equities,” said Binky Chadha, head of U.S. equities and global strategist at Deutsche Bank Securities Inc. “But the strong rally and above-average positioning (for this earnings season) argue for a moderate market reaction. .”

Obstacles galore

The obstacles investors currently face are no secret. The US presidential elections are just a month away, with Democrat Kamala Harris and Republican Donald Trump locked in a close, fierce race. The Federal Reserve has just started cutting interest rates, and while there is optimism about an economic soft landing, questions remain about how quickly central bankers will cut borrowing costs. And a deepening conflict in the Middle East is raising concerns about a new surge in inflation, with the price of West Texas Intermediate oil rising 9% last week, the biggest weekly gain in March 2023.

Read more: War risk in the Middle East puts Iran’s quiet oil comeback in the spotlight

“The bottom line is that the revisions and guidance are weak, indicating lingering concerns about the economy and reflecting election year seasonality,” said Dennis DeBusschere of 22V Research. “That helps set up the reporting season as a new event to remove uncertainty.”

And to make matters even more challenging, large institutional investors currently have little purchasing power and seasonal market trends are weak.

Positioning in trend-following systematic funds is now skewed to the downside, and positioning in the options market shows that traders may be unwilling to buy dips. According to data from Goldman Sachs Group Inc. commodity trading advisors, or CTAs, are expected to sell U.S. stocks even if the market remains flat over the next month. And volatility management funds, which buy stocks when volatility falls, no longer have room to add exposure.

History also seems to side with the pessimists. Since 1945, when the S&P 500 rose 20% in the first nine months of the year, the index has fallen 70% of the time in October, according to data compiled by Bespoke Investment Research. The index gained 21% this year through September.

Beam lowered

Still, there is reason for optimism, especially a lowered bar for earnings forecasts, giving companies more room to exceed expectations.

“The estimates have become a bit too optimistic, and now they are returning to a more realistic level,” said Ellen Hazen, chief market strategist at FLPutnam Investment Management. “It will definitely be easier to beat earnings because estimates are lower now.”

In fact, there is plenty of data to suggest that American companies remain fundamentally resilient. According to Bloomberg Intelligence, a stronger earnings cycle should continue to offset persistently weak economic signals, which could tilt the balance for equities in a positive direction. Even struggling small-cap stocks, which have lagged their large-cap counterparts this year, are expected to see better margins, writes BI’s Michael Casper.

Friday’s jobs report, which showed an unexpected drop in unemployment, allayed some concerns about a soft labor market.

Another factor is the Fed’s easing cycle, which has historically been a boon for US stocks. Since 1971, the S&P 500 has returned 15% annually during periods when the central bank has cut interest rates, according to data compiled by Bloomberg Intelligence.

These gains were even stronger when the rate cut cycles occurred during non-recession periods. In those cases, large caps saw an average annualized return of 25%, compared to 11% during a recession, while small caps in non-recession periods saw a gain of 20%, compared to 17% during a recession.

“Unless earnings are a big disappointment, I think the Fed will have a bigger impact on the markets between now and the end of the year simply because earnings have been fairly consistent,” said Tom Essaye, founder and president of Sevens Report Research. “Investors expect this to continue.”