As the pivotal fourth-quarter earnings season kicks off Friday, there appears to be a tug-of-war being waged on Wall Street.
On one side are those who believe the outlook has already been lowered enough to provide a springboard for better-than-expected results and stock gains, while on the other side are those believing that lackluster results and downbeat forward guidance will trigger further declines.
With the S&P 500
rallying more than 3% in January, and more than 8% over the past three months, the bulls seem to have the advantage. But there are also reasons to believe the bears could regain control once the flood of earnings reports start rolling in.
Six S&P 500 companies, which included four top banks, an airline and a health insurer, reported results before Friday’s open to officially kick off earnings season. And on cue, the stocks of all six companies fell in early trading, even though they all topped profit expectations.
“This scenario may explain why the fourth-quarter earnings season could become a market-moving event,” said Gail Dudack, chief investment strategist at Dudack Research Group, a division of Wellington Shields & Co. LLC.
Here are some factors to consider and trends to watch for in earnings reports that might show whether either bulls or bears will have the edge.
Have EPS estimates fallen by a lot — perhaps enough to provide a cushion for stocks?
The current blended growth estimate for S&P 500 earnings per share (EPS), which includes results already reported and consensus analysts estimates of those results not yet reported, is for a decline of 4.8%, according to FactSet. That would be the first year-over-year EPS decline since the third quarter of 2020.
Although consensus EPS estimates are usually lowered during the quarter, the fourth-quarter estimate was lowered much more than historical averages amid growing concerns that a recession was coming.
The fourth-quarter aggregate bottom-up EPS estimate for the S&P companies was $54.01 on Dec. 31, down 6.5% from $57.78 on Sept. 30, wrote FactSet senior earnings analyst John Butters in a recent research note. That compares with the average decline of 2.5% over the past five years.
A number of Wall Street strategists believe estimates have been lowered enough that most S&P 500 companies will beat expectations. Keep in mind that over the past five years, 77% of S&P 500 companies have beaten EPS estimates, and have beaten them by an average of 8.7%, according to FactSet.
The question is, will enough companies beat, and will they beat by enough, to favor the bulls?
Brad McMillan, chief investment officer for Commonwealth Financial Network, believes there’s a good chance that the answer is yes.
“Here, the news is likely to be better than expected,” McMillan wrote in a recent research note. “Earnings outperformed expectations in 2022, but that improvement was offset by the decline in valuations. With valuations stopping their decline, improvements in corporate earnings should provide a cushion for markets in 2023 and maybe even engineer some gains.”
2023 guidance has already been cut by a lot, but should probably be cut even more
As analysts cut their estimates for the fourth quarter, they usually also trim their views for the next year. Over the past five years, the average decline during the fourth quarter in bottom-up EPS estimates for the next year has been 0.2%, and over the past 10 years, that average decline has been 1.3%, FactSet’s Butters said.
But given growing concerns over a potential recession, the bottom-up EPS estimate for 2023 dropped by 4.4% to $230.51 as of Dec. 31, from $241.20 on Sept. 30.
While some may believe that suggests a potential recession may already be baked in, Dudack doesn’t believe that to be the case.
“[I]t is nearly impossible to estimate how weak earnings might be in 2023,” given the combination of interest-rate increases by the Federal Reserve and a weakened consumer, Dudack wrote. But to price in a recession, the EPS estimate would have to be cut by at least another 5 percentage points.
“A 10% decline in corporate earnings is ‘average’ during an economic recession,” she wrote.
Sales may rise, but volume declines could be more telling
While S&P 500 companies are expected to record less profit than they did last year, the current blended growth estimate for sales is 3.8%. Although that’s down from an estimated growth rate of 6.3% on Sept. 30 and would be the slowest growth in two years, at least it’s still positive. Or is it, really?
The dollar amount of sales a company reports is a function of the number of products sold, or volume, and the price that product is sold for. And there’s reason to believe that while sales might show growth, many companies may be selling fewer products.
That was the case for two early S&P 500 reporters.
Conagra Brands Inc.
with food brands including Hunt’s, Duncan Hines, Slim Jim and Birds Eye, earlier this month reported sales for the quarter through November that rose 8.3% from a year ago to $3.31 billion, enough to beat the FactSet consensus by 1.1%.
That growth came despite an 8.4% drop in volume, because the company raised the price of its product sold by 17%.
And frozen-potato-product maker Lamb Weston Holdings Inc.
reported sales for the similar quarterly period that climbed 26.8% from a year ago, to beat expectations by 11.2%, according to FactSet.
But that increase was only because price mix soared 30% to offset a 3% decline in volume.
COGS could be key, as moderation could boost margins and profits
Since inflation started surging, a key line item to watch in a company’s balance sheet has been cost of goods sold (COGS), sometimes called cost of sales. That’s because if COGS rises more than sales, then gross margins contract, which means the company makes less profit on each product sold.
Gross margin is reported as a percentage. To get that percentage, you must first subtract COGS from sales to get gross profit. Gross margin is gross profit divided by sales.
For Conagra, COGS rose just 3.8%, or less than half of sales growth, to $2.39 billion. Gross margin improved to 27.8% from 24.7%.
The company’s chief executive, Sean Connolly, said the relationship between sales and COGS had reached “a significant inflection point” to flip the gross margin story to one of recovery from one of compression.
For Lamb Weston, COGS increased just 11.7%, much less than half of sales growth, as gross margin expanded to 29.9 from 20.4%.
In a sign that slowing COGS growth could become a broader trend, the latest consumer inflation data showed prices fell 0.1% in December, while the annual inflation rate fell to 6.5% from 7.1%, well off its 40-year peak of 9.1% last summer.
Even if analysts haven’t cut earnings estimates enough to match how much the economy may have slowed at the end of last year, a bigger than-expected drop in COGS inflation could very well keep the market tide in favor of the bulls.