Earnings: Trampled Under Foot?

September 19, 2022 Liz Ann SondersKevin Gordon
The bear market has been driven by multiple compression, making valuations look relatively compelling. Yet, expected weakness in earnings may limit the upside potential for stocks.

In a few weeks, third-quarter earnings season begins, with much hand-wringing about whether this will be the season when economic weakness translates to earnings weakness. We believe the weakness in expected earnings growth is early in its trip to an ultimate negative (year-over-year decline) destination. Last week's FedEx news of an expected earnings implosion and the company's removal of all forward-looking guidance is a likely canary.

2Q22 recap

Before getting to the outlook, a recap of second-quarter earnings season is in order, since the official books are just closing now. S&P 500 earnings were up more than 8% in the second quarter, but excluding the Energy sector, they were down more than 2%. Shown in the chart below, the "beat rate" (percentage of companies that reported better-than-expected earnings) was more than 77%—above the long-term average of 66%, but below the prior four-quarter average of nearly 81%. Also shown is the sharp deceleration in the percent by which earnings beat expectations—from more than 20% five quarters ago to 5% during this year's second quarter (about half the prior four-quarter average of nearly 10%).

Lower beats

As of Friday, 78% of S&P 500 companies beat 2Q22 earnings expectations by 5.5%.

Source: Charles Schwab, I/B/E/S data from Refinitiv, as of 9/16/2022.

Stocks of companies beating estimates were rewarded on the day of their earnings' release, as shown in the blue bars in the chart below, but at a lower rate than the prior two quarters. Conversely, stocks of companies missing estimates were punished to a more significant degree than anything seen over the past five years.

Misses getting pummeled

The average S&P 500 member has outperformed the broader index in 2Q22 by 0.4% when beating analysts' expectations, while the average decline for a miss has amounted to -3.7%.

Source: Charles Schwab, Bloomberg, as of 9/16/2022.

Past performance is no guarantee of future results.

Revisionist future

Looking ahead, the estimated earnings growth rate for S&P 500 earnings in this year's third quarter is 5%; if the Energy sector is excluded, it's expected to be down nearly 2%. As shown in the chart below, the trajectory for earnings estimates for the remaining two quarters of this year and the first two quarters of next year has been decidedly down since earlier in the year. Estimates for the third quarter have fallen from more than 11% at their peak in June, while fourth-quarter estimates have been cut by more than half from their peak at the start of the year. For the first half of next year, estimates are also well below where they were earlier this year; although they did pick up in August before leveling out again.

Weakening path for estimates

S&P 500 year-over-year earnings growth is up 8.5% in 2Q22 but estimates for the remainder of the year and the first half of 2023 are rolling over.

Source: Charles Schwab, I/B/E/S data from Refinitiv, as of 9/16/2022.

Forecasts contained herein are for illustrative purposes only, may be based upon proprietary research and are developed through analysis of historical public data.

As shown in the chart below, there has been a significant deceleration in the percentage of S&P 500 stocks with positive three-month earnings revisions. The last slide as significant as this year's started in 2018 and did not find a bottom until the retreat from the lockdown era of the pandemic in 2020. We believe this chart gets worse before it starts to improve.

Fewer positive revisions

The percent of S&P 500 members with positive three-month revisions has dropped over the past year from nearly 70% to just above 30%.

Source: Charles Schwab, Bloomberg, as of 9/16/2022.

Better or worse matters more than good or bad

We all know earnings growth is a key underpinning of stock prices, but with important nuances in terms of the how and why. As with most economic and/or earnings data, trend tends to matter more than level ("better or worse matters more than good or bad"). As shown in the chart below, the year-over-year rate of change in S&P 500 earnings growth (yellow bars) is directly tied to the year-over-year rate of change in the S&P 500, with the S&P's descent into negative territory often preceding earnings' descent into negative territory (2008 being an exception).

Weight of weakening earnings

The pace of S&P 500 earnings growth has decelerated this year through 2Q while the rate of change in the overall S&P has gone negative.

Source: Charles Schwab, I/B/E/S data from Refinitiv, as of 6/30/2022.

4Q08's reading of -67% is truncated at -40%, 4Q09's reading of 206% is truncated at 80%, and 2Q21's reading of 96% is truncated at 60%. Past performance is no guarantee of future results.

One might think that high earnings growth rates would usher in strong stock market performance, but earnings are (obviously) reported after the fact, while stocks are a discounting mechanism. Earnings growth was more than 32% at the start of this year (as of last year's fourth quarter), yet a bear market slide began only three days into this year. Shown in the table below is a full-history look at S&P 500 performance relative to four earnings growth-rate zones.

High earnings = lower returns

Historically, the S&P 500 has performed the weakest when the year-over-year growth rate in earnings has been the lowest (below -20%).

Source: Charles Schwab, ©Copyright 2022 Ned Davis Research, Inc.

Further distribution prohibited without prior permission. All Rights Reserved. See NDR Disclaimer at www.ndr.com/copyright.html. For data vendor disclaimers refer to www.ndr.com/vendorinfo/. *Based on trailing 12-month earnings in accordance with GAAP (generally accepted accounting principles.). Past performance is no guarantee of future results.

Earnings growth of more than 20% has historically been accompanied by a barely positive annualized return of less than 2%; the best zone for stocks has historically been when earnings growth is between -20% and +5%. Perhaps no surprise is that the worst earnings zone for stocks is when earnings were imploding (worse than -20%). But what the trajectory of the data shows is that once earnings bottom and begin to accelerate, that's when the strongest market gains kicked in. Conversely, once earnings growth had surged to more than +20%, the market started to discount the inevitable turn down from peak levels.

What matters more than the growth rate of earnings is the percentage-point change in the growth rate of earnings. As shown in the table below, stocks had their best performance when the change in the growth rate was moving up by at least 11 percentage points (helping to explain last year's strong S&P 500 performance). Conversely, when the earnings growth rate was historically down by more than 18 percentage points (like now), stocks had their weakest performance (albeit positive).

Change in growth rate matters

Historically, the S&P 500 has performed the weakest when the point change in earnings growth has fallen below -18 percentage points.

Source: Charles Schwab, ©Copyright 2022 Ned Davis Research, Inc.

Further distribution prohibited without prior permission. All Rights Reserved. See NDR Disclaimer at www.ndr.com/copyright.html. For data vendor disclaimers refer to www.ndr.com/vendorinfo/. *Based on trailing 12-month earnings in accordance with GAAP (generally accepted accounting principles.). Past performance is no guarantee of future results.

Taking stock of valuation

Earnings are, of course, a component of most valuation metrics—certainly P/E ratios ("multiples") of several varieties. One of the clear themes throughout this bear market has been the significant reduction in multiples—namely, those based on forward and trailing earnings. The widely followed forward P/E for the S&P 500 collapsed during the pandemic-induced bear market in early 2020, only to rebound swiftly—from slightly more than 13 at its March 2020 trough, to 27 in late 2020. Multiple expansion took a breather from there through 2021, only to fully reverse as the bear market kicked in at the start of 2022.

Valuation reset

The widely followed forward P/E for the S&P 500 collapsed during the pandemic-induced bear market in early 2020, only to rebound swiftly—from slightly more than 13 at its March 2020 trough, to 27 at its September 2020 peak.

Source: Charles Schwab, Bloomberg, as of 9/16/2022.

The reversal this year was not only swift, but quite severe given the S&P 500's forward P/E fell by 28% from the beginning of the year through mid-June. Most of that re-rating was driven by large-cap growth stocks, given they were trading at hefty multiples as the new year began. As inflation's heat contributed to expectations of more aggressive rate hikes by the Federal Reserve (Fed), longer-duration/higher-multiple stocks were hit due to the higher discount rate used to value future earnings. The weakness helped accelerate the market's losses, but also aided the strong countertrend rally that lasted from mid-June through mid-August, as some investors sought to pick up battered companies that were then trading at relative discounts.

Absolute vs. relative

Our note of caution on viewing multiples as attractive in an absolute sense today is twofold. First, forward earnings growth has not yet contributed to the market's drawdown in a significant way this year. That means the "E" in the forward P/E has increased, while the P/E itself has declined. Given our view that forward earnings estimates remain too lofty, there remains a risk that analysts and companies guide down and reduce their estimates. If that occurs, it will put upward pressure on multiples (all else equal, which of course is never the case with the stock market), making stocks look relatively less attractive from here.

Attractiveness is in the eye of the beholder, however. Shown in the heatmap table below, you can see that there are myriad valuation metrics that suggest the market is both egregiously overvalued and opportunistically undervalued. As we often joke, at most moments in time, we can find the most bearish and most bullish investor in a room, and hand them each a valuation metric from the table below that supports their view on the market.

Pick a metric, any metric

Most market-valuation metrics that measure prices relative to fundamentals are expensive relative to history, while those that compare yields from stocks vs. bonds look relatively attractive.

Source: Charles Schwab, Bloomberg, The Leuthold Group, as of 9/16/2022.

Due to data limitations, start dates for each metric vary and are as follows: CAPE: 1900; Dividend yield: 1928; Normalized P/E: 1946; Market cap/GDP, Tobin's Q: 1952; Trailing P/E: 1960; Fed Model: 1965; Equity risk premium, forward P/E, price/book, price/cash flow, rule of 20: 1990. Percentile ranking is shown from lowest in green to highest in red. A higher percentage indicates a higher rank/valuation relative to history.

While many conclusions can be drawn from the table, we'll point out a few aspects worth noting in today's environment: 

  • Even though the S&P 500's forward and trailing P/Es have gotten crushed this year, they are still trading at relatively expensive levels relative to history.
  • While the equity-risk premium models may be comfortably in the light green zones, they have moved increasingly (and quickly) to the right (more expensive) as bond yields have climbed higher this year.
  • One may argue that the Rule of 20 has become increasingly important in today's environment, as inflation is still hovering near a 40-year high and weighing substantially on multiples. As such, that may indicate the market is still trading in an uncomfortably expensive zone.

Inflation has entered the discussion

Our goal in this writing is to reinforce that no one single valuation metric acts as the holy grail for determining whether the market is fairly valued. If anything, macro conditions often warrant a closer look at certain indicators. In today's environment of 40-year highs in inflation, more emphasis might be placed on the Rule of 20.  The "rule" simply states that the stock market is fairly valued when the sum of the S&P 500's forward (12-month) P/E and the year-over-year change in the consumer price index (CPI) equals 20. Evidenced by the mean-reverting nature of the metric going back to 1990, you can see in the chart below that there is some substance to that intuition. Yet, it's worth pointing out that there are different drivers of the sum when going back throughout history. In the late 1990s, the forward P/E was responsible for most of the gain, given CPI didn't even break through 4% year-over-year at its peak. Today is a much different story given CPI's 8.4% increase (as of August).

Play by the Rule of 20

The Rule of 20, which says the market is fairly valued when the S&P 500's forward P/E and CPI year-over-year rate add up to 20, currently suggests stocks are quite expensive relative to history.

Source: Charles Schwab, Bloomberg, as of 8/31/2022.

Rule of 20 (number at which dotted line is plotted) suggests, over the long term, the combination of the S&P 500's estimated forward 12-month P/E ratio and CPI year-over-year rate should revert to a sum of 20.

Another way to view the importance of inflation today is in the table below. Shown in the leftmost column are various ranges of the annual change in CPI. Moving to the right, you can see the S&P 500's average, lowest, and highest forward P/E in those ranges. Today's 8.5% CPI is consistent with an average forward P/E of 11.2, which is significantly lower than today's reading of 16.3. To be sure, that doesn't at all indicate that the market is set for an imminent collapse. As shown in the rightmost column, we have only been in the current CPI range for 3% of the time since 1958.

Inflation hits valuation

Today's 8.5% on CPI is consistent with an average forward P/E of 11.2, which is significantly lower than today's reading of 16.3.

Source: Charles Schwab, Bloomberg, Standard & Poor's. 1958-8/31/2022.

Numbers may not add up to 100% due to rounding.

Timing? Not so fast

The lack of a large sample size for inflation-related metrics underscores the difficulty in assessing market valuation at any given time. That especially holds true today, not only because of the inherent difficulty in seeing inflation's future path, but also because of its stubborn, slow decline. This should also serve as a reminder for investors that valuation is not (and has never been) a reliable near-term market-timing tool.

Returning to the widely followed forward P/E, as shown in the chart below, there is an incredibly weak relationship between its level and the S&P 500's performance one year later. In fact, there have been instances in which an eye-popping forward P/E above 25 preceded both a -20% decline and near 40% gain for stocks a year later.

No relationship status

Going back to 1958, there is virtually no relationship between the S&P 500's forward P/E and its price performance one year later, suggesting valuation is a poor near-term market-timing tool.

Source: Charles Schwab, Bloomberg, 1958-8/31/2022.

Correlation is a statistical measure of how two investments have historically moved in relation to each other, and ranges from -1 to +1. A correlation of 1 indicates a perfect positive correlation, while a correlation of -1 indicates a perfect negative correlation. A correlation of zero means the assets are not correlated. Past performance is no guarantee of future results.

While valuation analysis is a useful tool for assessing the market's attractiveness, we remain firm in the view that it depends on where investors place greater importance. As mentioned in the discussion around the heatmap table, investors who like to compare the stock market's yield to that of the bond market likely won't hesitate in saying stocks remain attractive today. Yet, investors who take issue with the rapid growth in multiples relative to the growth rate in the economy [market cap/gross national product (GNP)] may be less comfortable with the state of the market today.

In sum

Regardless of one's view, the indisputable reality today is that the Fed remains engaged in one of the most aggressive rate-hiking cycles in history. Confirmed by what we've seen this year, that has historically weighed on valuations. The added rub is that growth-heavy stocks represent a much larger portion of the market today compared to the last era with inflation running above 8%. If higher interest rates continue to dent those stocks' value, and earnings growth slows, there is less upside for profit margins.

This perhaps lends credence to the fact that it isn't precision around the magnitude of the decline in multiples that matters. Rather, it's the direction; and as of now, that continues to point downward…consistent with the downward trajectory of earnings growth estimates. At the mid-June lows, stocks were discounting a lot of negative news. Recent weakness clearly reflects still-hot inflation and a "don't fight the Fed" mentality. But still largely ahead is a further rerating of earnings estimates and likely continued volatility in stocks. Stay disciplined.

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Rule of 20 - Stocks are considered fairly valued when the sum of the S&P 500 forward P/E ratio and the year-over-year change in the consumer price index (CPI) is equal to 20 (or inexpensive when it's below 20).

Shiller's Cyclically-Adjusted P/E (CAPE) - This model uses an inflation-adjusted price for the S&P 500 and divides by reported earnings over the prior 10 years.

Tobin's Q - Developed by Nobel Laureate James Tobin, it's a fairly simple concept, but laborious to calculate (calculations are done by the U.S. government and the ratio's readings are provided by the Fed). It's often called the Q Ratio and is the total price of the U.S. stock market divided by the replacement cost of all its companies. A high Q (greater than .85) implies overvaluation.

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