Ben Graham, the value investor and Warren Buffett mentor, famously said the market is like a voting machine in the short run, but “in the long run it becomes a weighing machine.” For the past six months, the strong US stock market has been firmly in voting machine mode, and companies were overdue for a weigh-in that has now begun.
Since the lows in late October, valuation expansion has accounted for the lion’s share of the S&P 500 Index’s 23% return. The blended forward price-earnings ratio has climbed to about 20.1 times from 17.3 times at October’s low. Even with bonds offering more competitive yields, investors have proved more than willing to pay a widening premium for profits and cash flows, encouraged by the long-term promise of artificial intelligence and the consumer economy’s stunning resilience. That’s all fine and good, but it can’t go on like this forever, giving this earnings season some heightened importance.
In the near term, earnings are our best hope for a positive catalyst to offset all the negativity about inflation and interest rates. Three straight months of not-good-enough inflation data have led policymakers at the Federal Reserve to push out rate-cut expectations, and that means it will probably take at least three months of much better data to precipitate a cut — creating a potential dead spot for market sentiment. I started worrying about this good-news desert in mid-March, but recent data suggest we may be stuck here even longer than I initially expected.
In the recent stretch of the bull run, investors looked past higher rates, based in part on their belief that policy cuts were around the corner. That conviction is being severely tested. If investors continue to lose faith — even if, as I hope and expect, the inflation scare ultimately proves fleeting — the market could face an unpleasant short-term correction. Bank of America Corp.’s broad measure of investor sentiment — based on cash levels, equity allocation and economic growth expectations in its global fund manager survey — is at its most bullish this month since January 2022, a potential contrarian indicator that the market may be stretched and vulnerable. Only a shot of earnings optimism can mitigate the damage.
In the medium term, the next few months’ trading may also have meaningful implications for the real economy. With wage growth starting to cool and excess savings fading, asset markets have seemingly stepped in to help sustain US consumption, adding more than $10 trillion to household net worth in the past year. Whether or not it’s locked up in restricted accounts such as retirement plans, that wealth is burnishing household balance sheets and supporting otherwise so-so consumer sentiment. But where it’s helped during the bull run, it could also hit the economy on the way down, devolving into a vicious cycle.
Companies need to show that they’re capitalizing on economic strength to expand earnings; that the artificial intelligence optimism that started with the launch of ChaptGPT is more than hype; and that firms can continue to expand their bottom lines without returning to their 2021-2022 habit of jacking up prices — which would only keep interest rates higher for longer.
Not all earnings outlooks are created equal, of course, and one can imagine a scenario in which AI darlings Nvidia Corp. and Microsoft Corp. fan optimism; the other S&P 500 companies do “just good enough”; and the index still emerges from earnings season in the black. Totally possible. But with the Fed now on hold until — best case scenario — at least July, fundamental strength has to come from somewhere to offset high interest rates and the growing uncertainty about when they’ll start dropping (and by how much).
As things stand, bottom-up projections compiled by Bloomberg point to about 5% earnings growth for the S&P 500 from the same period last year, excluding the volatile energy sector. On the surface, that’s a blah number. But embedded in it are expectations for a pretty strong quarter for tech, communication services and consumer discretionary stocks. Materials, health care and industrials stocks, meanwhile, will likely be a drag.
Personally, I’m not in the camp that believes we’re experiencing some kind of bubble that’s about to pop with catastrophic consequences. Valuations are nowhere near the nosebleed levels of late 2021, and changes in index composition help justify the slightly higher multiples. Still, market narratives have a life of their own. As an avowed inflation optimist (see this), I increasingly feel like an island unto myself. Meanwhile, the economy probably grew about 2.9% in the first quarter, according to the Atlanta Fed’s GDPNow tracker, and that should translate into encouraging earnings and outlooks. One way or another, the stakes seem higher than usual during this corporate weigh-in season.
Jonathan Levin is a columnist focused on US markets and economics. Previously, he worked as a Bloomberg journalist in the US, Brazil and Mexico. He is a CFA charterholder.