Corporate earnings season is underway once again. With the second quarter of 2023 having just drawn to a close at the end of June, publicly traded companies will soon be coming forward to not only reflect on their recent operating results, but perhaps more importantly to update their projections on performance through the remainder of the this year and next. Overall, roughly 85% of companies in the S&P 500 Index will report their results and outlook over the next four weeks. What should we reasonably expect?
Grim at first glance. Expectations are already firmly set heading into the latest earnings season. Annual earnings per share on the S&P 500 are expected to decline when the reporting season draws to a close. The latest annual GAAP earnings projection for the S&P 500 in Q2 according to S&P Global is $178.18 per share, which is lower by more than -7% versus the $192.26 final reading from the same time last year in 2022 Q2. This would also mark the third consecutive quarter of annual GAAP earnings declines versus year ago levels. And it would also reinforce the bearish narrative for the economic and stock market outlook.
Signs of improvement when looking closer. Of course, looking at the annual earnings numbers on year-over-year basis does not tell the entire story. And when digging into the details, we find a much more constructive story for corporate earnings than first meets the eye.
For example, while annual GAAP earnings may still be declining versus a year ago, the per share value of earnings actually bottomed in 2022 Q4 at $172.75 and has been improving on a sequential basis over the last two quarters to $175.17 in 2023 Q1 and $178.18 currently estimated for the most recently completed quarter in 2023 Q2.
Quarterly GAAP earnings are also providing signs of encouragement following a previously tough spell. Quarterly GAAP earnings per share also bottomed at $39.61 in 2022 Q4 and are projected to come in more than +15% higher today at $45.75 once the 2023 Q2 season ends.
In addition, as inflation pressures have subsided, we have also seen a sequential quarterly improvement in corporate profit margins on the S&P 500 from 10.92% in 2022 Q4 to 11.93% in 2023 Q2. This is more than 100 bps of net income margin expansion over the past two quarters.
So while the headline annual numbers may still be signaling a declining earnings situation for the corporate sector, the data is much more encouraging for the bulls when digging down into the quarterly metrics.
Finding its footing on a high perch. Another positive associated with this measurable improvement in corporate earnings that began in 2023 Q1 and is projected to continue in 2023 Q2 is the fact that per share profits managed to stabilize and push back higher near the high end of their historical range.
Given that annual per share earnings on the S&P 500 could have reasonably been expected based on historical precedence to fall as far as the $110 per share range, the fact that they appear to have stabilized and started to rebound at such a high level is most supportive of stock prices that rely on earnings in the denominator of the price-to-earnings ratio to sustain more reasonable valuations.
What about valuations? Now that’s great that corporate earnings are providing support to valuations, but this still does not take away from the fact that stocks today are still mighty expensive from a long-term historical perspective.
For example, the more than 150 year average price-to-earnings multiple on the S&P 500 Index or its historical equivalent that preceded its existence (Dow Jones Industrial Average, etc.) is 16 times as reported earnings. Today, the S&P 500 is trading at more than 25 times GAAP earnings. This, of course, represents a +60% premium valuation relative to long-term history, which put simply is a lot.
Now it should be noted that stocks have been trading at a much higher multiple on average in more recent history. Over the past 36 years since the advent of the “Fed put” and the implicit (and sometimes explicit) understanding among stock investors that the U.S. Federal Reserve if able will likely hyperventilate with either the suggestion or delivery of policy support when the stock market falls by anywhere between -7% to -12% over any four week period, stocks have traded at a much higher 22 times earnings on average. But even with this more recent context, stocks are still trading at a +15% premium valuation today, and this is an environment where the risk-free rate is not pinned at 0% like it had been for so many years along the way during the post financial crisis period but instead north of 5%. There are reasonable alternatives, TARA!
A market of stock sectors. Yes, the stock market as measured by the S&P 500 is expensive today, but this does not mean that each of the 503 stocks that currently make up the S&P 500 Index are expensive. Instead, when taking a closer look, we actually find that most of the stock sectors within the S&P 500 are actually trading at their most reasonably priced valuations in five years.
How can this be possible? The answer lies with the Magnificent Seven, or the seven largest stocks by market cap in the S&P 500 Index. These include Apple, Microsoft, Amazon, Google, NVIDIA, Tesla, and Meta Platforms. Combined, these companies make up more than 27% of the entire benchmark index. Allow me to repeat for emphasis. Seven companies, or 1.4% of the more than 500 names in the S&P, make up 27% of the entire size. This is an extraordinary degree of market concentration we are seeing today. And the average price-to-earnings multiple associated with these seven giga cap stocks is a whopping 42 times earnings.
Why does this matter? Because exclude these seven stocks and then determine the P/E ratio of what remains of the S&P 500. Where do we end up? At a multiple less than 19 times earnings, which now represents a -15% discount relative to the 36 year “Fed put” era historical average.
Taking this to the next level, we see that most of the major sectors within the S&P 500 are actually trading at a reasonable if not healthy discount, as the only sectors trading at a measurable premium are Information Technology and Consumer Discretionary, both of which of course are led in size by the Magnificent Seven that come from these tech and tech adjacent stock market categories.
Such discounts still on offer in a broader market that has performed so well overall this year is yet another constructive signal moving into the second half of the year.
Bottom line. As we enter a new earnings season, a respectable cadre of analysts and experts are likely to detail how corporate earnings are still on the wane and stock prices are too expensive in such an environment. But when digging deeper into the numbers, we find a far more constructive story suggesting that not only are corporate earnings on the mend, but that valuations across many areas of the stock market are not nearly as expensive as what may be implied by the market as a whole.
Disclosure: I/we have no stock, option or similar derivative position in any of the companies mentioned, and no plans to initiate any such positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.
Investment advice offered through Great Valley Advisor Group (GVA), a Registered Investment Advisor. I am solely an investment advisor representative of Great Valley Advisor Group, and not affiliated with LPL Financial. Any opinions or views expressed by me are not those of LPL Financial. This is not intended to be used as tax or legal advice. All performance referenced is historical and is no guarantee of future results. All indices are unmanaged and may not be invested into directly. Please consult a tax or legal professional for specific information and advice.