Corporate America’s Profit Engine Is Just Starting to Rev Up

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(Bloomberg) — Don’t underestimate the famous profit engine of corporate America.

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Equity strategists are boosting earnings expectations for the S&P 500 over the next year faster than they have fallen, pushing a leading indicator that tracks the momentum of analyst reviews away from its November lows. After reaching minus 70% late last year, this measure — which focuses on forward 12-month earnings per share — is closer to positive territory at -28%, according to data compiled by Bloomberg Intelligence.

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The index has been described as a forward-looking measure of earnings expectations that may support the case for stock gains over the next year. The decline in revisions is a clear sign that the earnings story is picking up, according to Michael Casper, equity strategist at BI. In fact, the S&P 500 has historically seen an average increase of 5.1% in all four quarters after declining earnings-per-share growth, according to BI data.

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“This is good news for corporate earnings expectations and the trajectory of the stock market because this indicator has likely bottomed out at last,” Kasper said. “This means that more stocks are starting to see better times ahead – and the ultimately positive reading would confirm that the outlook is indeed rosier for 2024.”

So even though earnings for S&P 500 companies are expected to decline for the third consecutive quarter, earnings growth actually improves when the energy sector is excluded. BI data showed that the group’s estimates skewed lower for the broader index as inflation and commodity prices receded, with earnings growing without expecting the sector to return in the second half of the year.

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It’s the latest seemingly unlikely development of a massive risk rally in 2023 that is defying a Wall Street jitter that has been troubling everything from a recession to aggressive Fed hikes.

While nine of the 11 sectors in the benchmark see negative earnings revisions over the coming year, two major groups known for their cyclical index — industries and discretionary — have turned positive, while technology is also about to reach that encouraging threshold.

This is a pivotal development because the industrial and discretionary sectors, which are linked to the health of the US economy, were among the first to lead a slowdown in earnings growth last year. This time, they’re leading the rebound in profit expectations as many companies in the two industries reopen post-pandemic economic plays. Of course, energy faces the greatest pain as inflation subsides, with crude oil prices falling subsequently.

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With that said, there remains a lot of concern that the stock market could be dragged further by an economic slowdown or recession which would cut earnings even deeper, especially given persistent concerns that the still-hawkish Fed will derail the rally. This has set off alarm bells for some in the wake of this year’s massive rebound in big tech companies, leaving stock multiples rich and market focus in extremes.

“The big risk is that valuations remain too high,” warned Brian Frank, portfolio manager of the Frank Value Fund. “If there is a significant drop in overall earnings growth for the S&P 500, there will be a lot of potential downsides for the broader stock market.”

Wall Street analysts expect that S&P 500 companies will see the largest contraction in earnings growth during the second quarter, when earnings are expected to decline 9% year over year. With just over 5% of the companies in the index reporting, earnings growth for the period is on track to contract by 9.3% year-to-date.

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However, Dan Aye, chief investment officer at Fort Pitt Capital Group, believes that the impetus from upward revisions to earnings estimates may start to overtake Fed rate policy as the primary driver of the stock market in the coming months.

Why? Well, other positive signs are that broad earnings growth will return in the second half of the year, particularly as producer price inflation continues to improve — a crucial moment that promises to boost margins, and which should help usher in a better-than-expected earnings outlook for the second quarter.

“Probably the worst pain in earnings is over, unless there is a situation where there is a deep recession – which we don’t see since inflation eased significantly,” Ay added. “It’s very clear that the stock market is starting to recognize brighter times for earnings a while ago, as evidenced by the stock rally this year.”

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