Surpassing Expectations: A Deeper Look into Corporate Earnings

Despite exceeding third-quarter earnings forecasts, the stock market remains unimpressed with the strong figures. The recent earning season has produced favorable results overall, with S&P 500 companies reporting aggregate sales that exceeded Wall Street expectations by 0.6% according to Evercore. Moreover, average per-share earnings have surpassed estimates by an impressive 8.9%.

These robust earnings outcomes are a reflection of the third quarter's unexpectedly strong economic growth. Notably, the fact that the earnings "beat" has outperformed sales suggests that profit margins have also fared better than anticipated. This is particularly remarkable considering the stabilization of product costs and employee compensation. Encouragingly, all sectors have surpassed bottom-line estimates thus far.

However, despite the positive performance in corporate earnings, the S&P 500 has experienced a 3% decline since the start of earnings season, and it has plummeted by approximately 10% from its peak in late July 2023.

The explanation is rather straightforward: stocks were excessively overvalued as earnings season approached, and most companies have refrained from revising their profit forecasts.

Even companies that surpass earnings estimates are not being adequately rewarded in the stock market. Over the past five years, when firms have outperformed analyst predictions for both earnings and revenue, their stocks have typically risen by an average of 1% on the trading day following the earnings announcement. However, during the third quarter of 2023, companies surpassing both top and bottom-line estimates have only experienced a marginal average gain of 0.5% on the trading day after their earnings report, as reported by Evercore. When considering the stock performance of companies that fell short of profit expectations, the average stock price reaction on the release day for all earnings reports this season has been a 1% decline.

Stock Valuations and Earnings Expectations

Stocks have been on a rally for most of this year, with the S&P 500 trading at a relatively high valuation multiple. At the start of the year, the index was trading at just under 17 times analyst's per-share earnings estimates for the next 12 months. However, it has now increased to about 18 times.

This elevated valuation makes it imperative for earnings results to exceed expectations significantly in order to justify the current high share prices. The concern is exacerbated by the fact that companies have not raised their profit forecasts for the fourth quarter.

Since October 3, none of the companies in the S&P 500 have revised their fourth-quarter EPS guidance in their comments on earnings releases. FMCCorp. (FMC), a chemical maker, even lowered its fourth-quarter profit guidance due to customers destocking and limiting purchases in anticipation of subdued demand.

While this poor guidance may not come as a surprise, it indicates that higher interest rates will likely take a toll on future economic growth. Some companies are already witnessing signs of slowing growth, and the stock market is anticipating this reality by looking beyond third-quarter results.