A Make or Break Earnings Season

Shah Gilani|April 12, 2024

It’s make or break time.

The stock market made multiple all-time highs in the first quarter…

And now earnings are about to roll in.

Will results keep the market’s express train running? Or will they derail it?

Despite rising concerns over stubborn inflation… uncertainty over interest rate cuts… and fears over geopolitical tensions…

The S&P 500 not only has defied gravity… but also is testing the limits of a reasonable valuation.

The S&P’s trading at a forward P/E ratio of 20.5x. It has eclipsed the five- and 10-year averages of 19.1x and 17.7x, respectively.

Is that optimism warranted?

First-quarter earnings reports will lay bare whether stocks can live up to their record-breaking highs and aggressive valuations… or be brought back to Earth.

Earnings haven’t been this important for more than a year.

Clear Value

The evolution of the S&P 500’s valuation tells a story of investor sentiment and economic cycles.

Picking up the pieces after the 2008-09 financial crisis, the index’s valuation went from a tepid 15x in 2014 to a stronger 17x in 2017. That change reflected a resurgence of confidence in corporate America and confidence in the stability of interest rates.

We’ve seen that optimism in recent years as well… as the S&P’s valuation went from 15x in 2022 to the current 20.5x. The increase mostly underscores the market’s faith in the Federal Reserve… and its ability to tame inflation without stifling economic growth.

Of course, the optimism has also been boosted by the Fed’s suggestion of rate cuts in 2024.

But now, with inflation persisting and higher-for-longer rate expectations replacing cut prospects, the specter of recession looms again. Those robust valuations might topple.

Historical data bears witness to this. The pandemic and the Fed’s aggressive rate hikes in 2022 ignited a sharp contraction in P/E multiples.

But the market’s current valuation suggests a stubborn belief in the resilience of the U.S. economy and its corporate sector.

Earning Their Keep

The first quarter of 2024 saw the S&P 500 soar 10%, a remarkable feat that contrasted sharply with the muted earnings growth expectations of just 3.9% for S&P 500 companies in the quarter.

The new all-time highs we saw came courtesy of the remarkable 8% earnings growth from the last quarter of 2023.

Clearly, investors bid up stocks in Q1, hoping for continued earnings growth momentum.

And we’ll likely see further market gains… even if earnings across the board don’t beat expectations.

Here’s why…

The tech sector carries the bulk of any earnings growth.

The top seven growth companies are expected to see a 38% rise in profits, while the broader index faces challenges.

If the earnings of the big tech names and AI darlings don’t reflect their positions as leaders of the market, it won’t matter much what the lower 490 or so stocks do.

And if they do beat expectations… it won’t matter much what the lower 490 or so stocks do.

The record levels of corporate cash and free cash flow bolster the potential for shareholder returns and business expansion. We could see a recovery in capital deployment.

Improving operating margins – driven by cost-cutting measures and the AI boom – hint at an upward trajectory in profitability.

At least that’s what analysts are counting on.

Me too.

My No. 1 market motto is “the trend is your friend.” The trend in earnings has been very positive for big tech darlings… even though analysts have predictably been lowering Q1 earnings forecasts.

I expect key names to beat on earnings, margins and revenues and sustain the rally as investors continue to pile in.

But if I’m wrong and earnings disappoint… we could see investors take profits off the table instead of chase performance.

Things could get ugly… and we’ll be ready to buy the dip.