Profits aren’t what’s in trouble

Earnings season has kicked off with 74 S&P 500 companies reporting last week. 20% of S&P 500 companies have now reported earnings, with 79% and 69% beating consensus earnings and sales estimates, respectively. Despite strong results overall, the S&P 500 fell almost 3% and the communication services sector fared even worse. This week is the busiest week of the reporting season, with 180 S&P 500 expected.

Blended earnings, which combine actual numbers and estimates from companies that have yet to report, rose from 5.1% to 6.6% year-over-year. Earnings beats in the Communication Services, Financials and Consumer Discretionary sectors were primarily responsible for the improvement.

Mixed revenue growth also improved from the previous week, rising from 10.8% to 11.1% year-over-year. Sales in the energy and materials sectors illustrate the sharp rise in commodity prices. Energy, utilities and consumer staples remain the only S&P 500 sectors with year-to-date price gains.

Earnings performance exceeded expectations at the end of the quarter. Combining actual results with consensus estimates for companies that have yet to report, the blended earnings growth rate is now 6.6% year-over-year, versus 4.7% expected at the end of the quarter. Despite the decline in the percentage of companies beating sales estimates, the compound revenue growth rate fell to 11.1% from 10.7% year-over-year at the end of the first quarter. Estimated calendar year earnings growth for 2022 fell to 10.9% year-over-year, so earnings expectations this year do not appear to be driving the decline market last week. Worries don’t show up in 2023 earnings estimates either, as they were down just a tenth of a percent to 10.3% year-over-year.

The epicenter of the stock market declines came from the communication services sector and, more specifically, from the media group, with Netflix

NFLX
(NFLX) down nearly 37% in the past week after its earnings release. Thanks to better-than-expected earnings from Netflix and AT&T(T), the sector posted well-better-than-expected earnings for the quarter. Unfortunately, Netflix’s first drop in subscribers more than offset the quarter’s better earnings. Concerns about Netflix’s growth in jeopardy also spilled over to the media sector, with the group falling nearly 9% for the week. In addition, it contributed to considerable difficulties in stocks with high expected future earnings growth rates. As a proxy for this group, the RA

AR
K Innovation ETF (ARKK

ARKK
) was down more than 11% for the week, bringing its year-to-date decline to nearly 45%.

The last week of communication from the Federal Reserve (Fed) before the period of calm also added to the weight of the market. Based on Fed chatter, markets have increased the amount of interest rate hikes over the next eighteen months to just over ten 25 basis point hikes (0.25%). Additionally, fed funds futures are now pricing in a low probability of a 75 basis point (0.75%) hike on May 4.^and meeting, with a 50 basis point (0.50%) a fait accompli. The specter of the Fed being forced to continue raising interest rates to control inflation even as the economy begins to slow significantly is not a pleasant thought for future earnings prospects and hence stock prices. .

The S&P 500 is now nearly 11% below its January peak. While this all sounds very grim, history suggests that future returns tend to be better than average when the market corrects more than 10%. According to Goldman Sachs, the S&P 500 has returned 76% positive after declines of 10% since 1950. Given the downside risk to the economy and the current inflationary environment, investors should focus on quality and dividend growth plus companies with pricing power when looking for opportunities during this sale. Quality is defined as a high return on capital, consistent earnings, and low level of debt, which should help the company weather any economic downturn.

Along with the barrage of earnings this week, investors are getting a first look at first-quarter economic growth. Economists expect an annualized growth rate of 1.1% quarter over quarter after the 6.9% increase in the fourth quarter of 2021. While GDP is firmly in the rearview mirror, the Current worries about Fed policy and the risk of a future recession could give it more impact than it usually carries.