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  • Analysts' S&P 500 earnings estimates call for a year-over-year drop in Q4 results.
  • A weaker Dollar, lower commodity prices, and moderating labor costs could shift from headwinds to tailwinds as soon as the second quarter.
  • A declining earnings outlook could eventually make it easier for companies to beat expectations.

Previously, I wrote how earnings and unemployment should be the focus in 2023 rather than inflation. We’ve already seen inflation moderate from sky-high levels last year. As long as December’s Consumer Price Index CPI on Thursday is unsurprising, I think most investors' attention will pivot quickly to the fourth-quarter earnings season. 

Although Q4 earnings results aren’t likely to impress, overly bearish outlooks could the stage for stocks to trend higher.

Downward revisions dominate

Analysts are prone to playing catch-up, so their earnings estimates have been chasing poor earnings results lower since midyear. That was especially true last quarter. They’ve gone from expecting low single-digit fourth-quarter earnings growth to predicting the first decline in year-over-year earnings since COVID crimped corporate profits in 2020.

On September 30, analysts expected S&P 500 earnings to grow by 3.5%. However, a larger-than-usual number of downward earnings revisions has them now expecting earnings will fall 4.1% from one year ago, the first drop since a 5.7% decline in Q3 2020. 

Downward revisions are common every quarter, but not to this extent. Using a bottom-up analysis of median earnings estimates, FactSet concludes that EPS estimates for the S&P 500 have fallen by 6.5% since September, far more than the average 3.8% drop in quarterly expectations over the past 20 years.

Materials, consumer discretionary, communication services, and information technology have been hardest hit, according to FactSet.

Analysts' outlook has soured for 97% of S&P 500 materials sector stocks. As a result, the basket is expected to see fourth-quarter earnings fall 26% versus an 8% expected drop in September. LyondellBassell Industries  (LYB)  and Corteva  (CTVA)  have seen the biggest downward revisions.

Amazon  (AMZN)  and Target’s  (TGT)  lowered expectations are the biggest reason for an expected 20% drop year-over-year in consumer discretionary earnings. The outlook was for a 7.1% decline in September.

Downbeat outlooks for Alphabet  (GOOGL) , Meta Platforms  (META) , and Walt Disney  (DIS)  are mostly responsible for analysts’ expectations that communication services earnings will retreat 19% from last year. In September, the estimate was for a decline of 6.8%.

Similarly, growing pessimism for earnings at Apple  (AAPL) , Intel  (INTC) , and Microsoft  (MSFT)  is behind an expected year-over-year earnings decline of 9.5% compared to a manageable drop of 1.5% expected in September.

The only bright spot is energy, which has propped up S&P 500 earnings throughout 2022. Analysts think energy EPS will climb 63% from one year ago in Q4. That’s because while oil prices retreated, they remained higher year over year while production also increased.

If we eliminate the positive impact of energy (a cyclical industry after all), then S&P 500 earnings would be expected to fall 8.5% in the fourth quarter!

Overall, the level of earnings pessimism is concerning, but it also means that the bar for companies to overcome has been lowered. It’s too soon to say estimates are too low, but contrarians are right to wonder if downbeat projections are setting up easier comparables and poor earnings are already priced into stocks.

Dollar weakness should help

The typical S&P 500 stock gets about 40% of its sales overseas, so converting those sales into a strong Dollar was a big drag in 2022. Fortunately, the Dollar has declined since September, so that drag is less onerous. The Dollar fell 7.7% last quarter, so sequentially, companies should experience some relief. However, the Dollar remains higher than last Spring, so year-over-year results will remain under pressure until Q2, assuming the Dollar stays where it is or declines further.

Overseas revenue varies from sector to sector, but the Dollar’s impact is greatest on information technology stocks. About 58% of that sector’s sales are outside America. International sales account for 42%, 44%, and 55% of communication services, consumer staples, and materials revenue, respectively. So, they can also benefit from the Dollar's slide.

Falling commodity costs and moderating labor costs may also help profits this year.

The Invesco DB Commodity Index ETF  (DBC)  has fallen from $31 in June to $24, so it's about back to where it was trading in March. The decline suggests commodity costs should be sequentially manageable, with the potential to support margin as soon as Q2.

The latest labor cost data suggests it won't be as big of a headwind as it's been, either.

Headcount reductions are happening at many high-profile growth companies, including technology companies. Also, fewer hours worked and stable year-over-year wage growth resulted in average weekly earnings growth of 3.9% in November, down from 5.3% the previous year and 4.2% in September.

The retreat suggests that the bottom line for sectors where selling, general, and administrative expenses make up a large proportion of revenue, including information technology, could benefit.

For perspective, SG&A expenses totaled 36% of information technology revenue pre-COVID, above the 24% average for all sectors. In Q3, net profit margin increased for 51% of information technology companies. 

If we assume (dangerous, I know) the Dollar, commodity input costs, and labor costs trend lower, then downward earnings revisions overstate earnings risks as soon as Q2 2023 if the economy sidesteps a deep recession.

The Smart Play

The prospect of lower earnings is worrisome because valuation depends on the multiple investors will pay for earnings and the absolute earnings level.

If prices are constant, declining earnings estimates increase the forward price-to-earnings ratio, making stocks appear more expensive. If interest rates remain high, then the risk-free Treasury yield reduces the multiple investors are willing to pay for future cash flows. The one-two punch keeps a lid on valuation, capping the upside.

That said, valuation isn’t ridiculously high now that stocks have retreated. The S&P 500’s forward P/E ratio is 16.5, up from 15.2 in September but still below the 10-year average of 17.2. If earnings wind up better than feared, and the Fed puts the brake on rate hikes after February (a possibility), then early cycle stocks like technology may find their footing.

Currently, estimates are for S&P 500 EPS to fall 0.1% year over year in the first quarter and increase 4.8% in 2023. I suspect the first quarter outlook will trend lower in the coming months as it usually does (see my earlier comment re. 20-year average downward revisions).

The current full-year S&P 500 consensus earnings forecast works out to $230. If we assume a range of $220 (representing roughly no EPS growth in 2023) to $230 and a P/E multiple of 15 or 18, then a loose S&P 500 range would be 3,300 to 4,140. Of course, analysts’ expectations for S&P 500 earnings vary. For instance, JP Morgan thinks S&P 500 will earn just $205.

Active investors can create their own range to fit earnings and valuation assumptions to decide when to fade (at the high end) and buy (at the low end). For example, Real Money Pro’s Doug Kass assumes a range of 3,700 to 4,100, and he’s been adjusting net long exposure using that range for months.

However, remember that even if the bottom falls out on earnings, causing the S&P 500 estimate to collapse, a spike in the P/E ratio might not preclude a bottoming in stocks. In the past, stocks have bottomed when the P/E skyrocketed because of lowered earnings and forward estimates, including in 2001 (the Internet Bust) and 2009. It should also be remembered that stocks bottomed in March 2020, despite earnings falling in Q2 and Q3 2020. 

Overall, watch earnings reports closely over the next few quarters. If profit margin pressures ease because of fading dollar headwinds, easier labor costs, and lower commodity prices, overly bearish earnings estimates could allow more companies to beat than miss as the year progresses, propelling stocks higher. 

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