How Lower Earnings Forecasts From Analysts Are Good for the Stock Market

This is important to keep in mind because, for a year now, earnings estimates have dropped as higher interest rates have put the squeeze on spending—businesses and households—and, in turn, corporate profits.

This year’s S&P 500’s aggregate earnings per-share estimate is off from its peak of almost $250 in early 2022, dragging down 2024 estimates about 10% to $244, according to

FactSet
.

Slowing revenue growth together with increases in product costs and employee pay has lowered profit margins and bottom-line dollars. Those drops provide less cash flow for share repurchases, furthering pressuring EPS. 

Initially, the combination crushed stocks. The S&P 500 dropped 25% from its record closing high 4796 again in early 2022 to a closing low 3577 late that year. Now, the index is at just over 4500 and 26% above its low, as it inches closer to its record high.

Driving the rebound has been optimism that the cuts to EPS forecasts are almost over, and that profits will safely grow from here. 

But there’s one last hurdle. Earnings estimates should drop—at least a bit—over the next few months. 

History shows that fourth-quarter estimates, on average, have dropped by 8% from February to the end of the year for the past two decades, according to

Citi
.

This year, they’re down 6% since February. 

Lower fourth-quarter estimates mean this year’s EPS would be lower. If analysts keep their current 2024 earnings growth estimates from a lower base of 2023 earnings, profit dollar estimates for next year would drop. That makes sense given that the negative impact of higher interest rates on the economy are usually delayed. Economic growth has barely slowed down since rate increases began early last year, so growth should indeed slow soon. 

Consistent with that, companies have sent louder warning signals on earnings calls.

Chip maker On Semiconductor (ON) gave disappointing fourth-quarter sales guidance on the back of weakening automobile demand. Peer Texas Instruments (TXN) also gave a gloomy outlook, while

Meta Platforms

(META) warned of a slowdown in spending from marketers in the face of a wakening consumer.

Company mentions of “macro risks” and related phrases hit about 70 in the past few weeks, near a decade-high and up from below 50 in the previous period, according to

Morgan Stanley
.

There is an upside, though. After analysts pencil in another round of slightly lowered EPS estimates over the next few months, forecasts should stabilize.

The coming deceleration in economic growth will stabilize as rates are finished rising because the Fed recognizes that the inflation is just a percentage point above its 2% annual target. The Fed could even cut rates next year.

So companies could be less gloomy in their outlooks next year, allowing modest beats of conservative EPS expectations to lift analysts profit estimates.

“We suspect that this should set up for yet another solid positive surprise,” wrote Citi’s equity strategist Scott Chronert. 

Not only can companies beat next year, but their profits should grow. Sales are expected to grow 5.2% next year, according to FactSet, while less cost inflation will help profit margins inch higher. Then factor in stock buybacks and EPS can grow 11.5%. That growth could more or less hold up because analysts may cut estimates within the next few months, only for companies to then surpass those projections. 

Leading the growth will be technology and healthcare. These two sectors have accounted for about a third of the S&P 500’s earnings this year, according to Citi. 

Technology EPS is expected to increase 14% because of artificial intelligence, which has expanded market opportunities for cloud solutions and the chips that power them.

Healthcare EPS can grow 19% off a low comparison from this down year. Insurers, for instance, are getting hurt by higher payouts as a result of Americans going back to their doctors after the pandemic. Those reimbursement costs should moderate in 2024.

So what’s the upshot? Two things can be true at the same time. Analysts will keep lowering their profit forecasts and stocks will keep gaining.

What makes these two contradictions possible is confidence. As long as the market trusts that earnings will increase and estimates will bottom out soon, the S&P 500 will keep rising. 

Indeed, the market is on a march.

Write to Jacob Sonenshine at jacob.sonenshine@barrons.com

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2023-11-20 20:26:00