The Earnings Recession Could End Soon. Now What?

October 12, 2023
A run of shrinking quarterly profits may finally end soon, but it's probably not time to break out the champagne just yet.

The recession in corporate earnings could end with the coming third-quarter reporting season—but will that be enough to lift the stock market from its late-summer slumber?

An "earnings recession" occurs when corporate profits decline on an annual basis for two straight quarters. As of the end of second quarter, average quarterly earnings for companies on the S&P 500® Index had declined for three quarters in a row.1

Analysts polled by FactSet now expect average earnings to have shrunk just 0.3% in the third quarter from a year earlier, before accelerating to a 7.8% expansion in the fourth quarter.2 (The firm issues a new estimate each Friday ahead of and during earnings season, so this could change.) They're also forecasting 12.2% calendar-year growth in 2024, which would be a big step up from this year's anemic forecast of a 0.9% calendar-year rise.

"Whether or not forward earnings estimates are too optimistic remains to be seen. However, they might not seem realistic this time, given the expected coming impacts from tighter Fed policy and a slowing global economy," says Schwab Senior Investment Strategist Kevin Gordon. "Companies will have to demonstrate durable recoveries in demand, as opposed to boosting earnings solely via cost cutting."

So, what's going on here?

Year-on-year comparison

Let's start with base-of-comparison effects. The "recession" quarters of late 2022 and early 2023 suffered from unfavorable comparisons with year-earlier periods when the economy was in full post-pandemic recovery mode. Those effects should reverse going forward.

Base effects have been particularly strong in the energy sector, which led earnings gainers with triple-digit profit growth in 2022 as Russia's invasion of Ukraine boosted oil prices.3 Earlier this year, though, the sector started to weigh on overall earnings as crude prices fell. Now, as anyone with a gas tank knows, crude prices have been rising pretty sharply again. Consumer spending also picked up in the latter half of the summer.4

While the end of any recession is to be applauded, you might have sensed that these top-line numbers, on their own, may not be enough to cheer investors. Rising interest rates and inflation from soaring energy costs could take a toll, but that's not all.

Rich valuations

Stocks approach earnings season at a relatively high valuation compared with the historic average.

Despite the earnings recession, the S&P 500 Index is up about 14% so far this year, mainly reflecting gains by mega-cap stocks amid excitement over artificial intelligence (AI).5 When the index goes up and earnings go down, it raises the market's valuation. The S&P 500's forward price-earnings ratio (P/E) reached approximately 20 at its summer peak after starting the year near 17. It's down slightly from that now, but the current level near 18 remains above the historic average of around 17. That could mean the expected improvement in earnings over the next year is already reflected in stocks' current prices—leaving them little room to go higher.

Top-line issues

And then there are revenues. Analysts expect revenue for S&P 500 companies to have grown just 1.7% in the third quarter from a year earlier. That's an improvement from the second quarter's 0.9% expansion, but a big step down from the 10% year-on-year increase of a year earlier. Of course, last year's numbers partly reflect a surge in energy company revenue as oil prices soared. But four other sectors also recorded double-digit revenue growth that quarter, and just one sector (financials) accomplished that in the second quarter this year. Analysts aren't expecting any sector to deliver double-digit revenue growth in the third quarter.

The second-quarter "beat rate"—or the percentage of companies that beat Wall Street analysts' revenue forecasts—was at its lowest level in years. And some "beats" may have owed a lot to cost cutting.

So, be careful of horse-race-style media coverage focused on who's beating estimates and who isn't. Cost-cutting can make a bottom line look better, but if revenue growth stalls, a company might have trouble growing profits in the future.

“Upcoming earnings season won't be just about beat rates, but also about the differential between the bottom and top lines," writes Liz Ann Sonders, chief investment strategist at Schwab.

Inflation's bite

Another thing to track is nominal versus "real" earnings growth, which accounts for the effects of inflation, Liz Ann says.

Companies that boosted revenue by raising prices could find that a hard trick to repeat. Many consumer-related companies reported higher revenue but fewer customers in recent quarters.6

Those who did shop had to pay up due to higher prices, but consumers may be growing more resistant to price increases as inflation has fallen. Some have also opted to delay big-ticket purchases.

Beyond the numbers

Earnings season isn't just about the last-quarter's numbers. It's also an opportunity to hear directly from company executives during earnings calls about what issues they're struggling with.

This coming batch of calls could help investors better understand how the economy and interest rates are affecting business. Here are some other factors to listen to.

  • Inflation. 296 S&P 500 companies used the term "inflation" during their second-quarter earnings calls—the lowest since second quarter of 2021, and down from the more than 400 that mentioned it during the second quarter of 2022, according to FactSet. That aligns with months of government data showing inflation pulling back from the peak 9% levels seen in mid-2022. The question is whether companies are seeing any benefit, either through better margins or improved customer demand.
  • Oil prices. Crude oil prices, which rose 16% from late August through mid-September, could be a wild card.7 Higher fuel prices are already affecting some companies' bottom lines, particularly airlines exposed to the rising price of jet fuel. Higher fuel prices could hurt margins for railroad and trucking firms that rely on that energy source. That said, while fuel costs represent a healthy portion of airlines' expenses, they're generally less of a factor now for both companies and consumers than they were 20 or 40 years ago. Energy and gas spending as a percent of consumption has been in a secular downtrend, says Kevin. Even during the 2022 oil pop, oil's share of consumption rose to just 3.3%, which was still half of what it was back in the 1970s.
  • China. China's post-pandemic economic recovery hasn't been as strong as many had anticipated. While China accounts for only about 5% of revenue for S&P 500 companies, according to Barron's, some of the largest U.S. firms in the tech and communications services sector derive a higher-than-average percentage of their revenue from China. The country's flagging economy isn't the only worrisome factor here. Trade tensions between the United States and China, including U.S. bans on semiconductor chips and other key technology, could hurt some companies.
  • Labor: Payroll growth has generally slowed since the post-pandemic re-opening phase in 2021, though the economy added a surprisingly large number of jobs in September. Earnings season often coincides with company layoff announcements, so be on the lookout. Executives on company earnings calls may also be asked about hiring trends and the jobs outlook in their industry.
  • Holiday shopping: Retailers may also have something to say about how the Christmas shopping season is shaping up. Consumer spending makes up 70% of the U.S. economy and the fourth quarter is when retailers traditionally rack up a chunky portion of their sales. Stay tuned.

1Source: Refinitive I/B/E/S as of October 10, 2023.

2Source: FactSet Earnings Insight, October 6, 2023.

3Sources: FactSet Earnings Insight, February 17, 2023, and "Big Oil doubles profits in blockbuster 2022," Reuters, February 8, 2023.

4Source: Bureau of Economic Analysis data as of August 2023

5S&P 500® Index as of October 10, 2023.

6"Department Stores Are Maxed Out," The Wall Street Journal, August 23, 2023.

7Source: CME Group West Texas Intermediate (WTI) Light Sweet Crude Oil futures, August 15, 2023–September 27, 2023.

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