CIO looks for a good results season, but after such a strong period of equity market performance, they think some consolidation of market gains is likely. (UBS)

In particular, the job market has remained healthy: The unemployment rate is near historical lows, demand for workers is moderating but remains strong, nonfarm payroll growth is still solid, and initial claims for unemployment insurance have stayed fairly low.

This has supported consumer spending, which continues to benefit from excess cash on household balance sheets and rising real income as inflation cools. As a result, economic data has consistently surprised to the upside over the last several months. There has even been a pickup in new home sales—one of the most cyclical areas of the economy. As a result, we expect second-quarter earnings season to also reflect these positive trends.

Earnings will beat

Corporate America usually does a very good job providing conservative guidance, so companies often “beat” analyst estimates. This quarter looks no different. Over the last three months, the bottom-up S&P 500 2Q EPS estimate has fallen by almost 4%, in line with the normal pattern over the course of a quarter.

In conjunction with the strong economic surprise data and the results from the early reporters, we expect that S&P 500 companies will once again exceed expectations. Incorporating our expectations for earnings beats, we look for 2Q S&P 500 EPS to decline 3–5% year-over-year. This quarter looks poised to be the trough in year-over-year earnings growth.

Across sectors, there is significant dispersion in profit growth. Consumer discretionary growth is being propelled by easy comparisons on the heels of very weak numbers last year when goods demand started to disappoint. On the flip side, the commodity-oriented sectors, such as energy and materials, will see significant declines in profits due to difficult comparisons. The Russian invasion of Ukraine pushed many commodities to very high levels last year, but many commodity prices have fallen back to pre-invasion levels. Excluding the energy sector, earnings could rise slightly. The median company in the S&P 500 will probably produce 3% earnings growth.

But what about the market "bar"?

So while the “bar” for earnings looks beatable, the setup in the stock market itself looks a bit different. Over the past six weeks, the S&P 500 is up nearly 8%, the best performance leading up to an earnings season since the first quarter of 2021. To us, this suggests that investors may already be anticipating a favorable earnings season. To the extent that good earnings results confirm that the economic risks have receded, investors may rotate into some of the more economically sensitive market segments that have lagged the market gains this year. Within this group, we prefer energy and industrials. We also like the equal-weighted S&P 500 relative to the normal market capitalization version of the S&P 500. The equal-weighted index has underperformed the S&P 500 by almost 9 percentage points year-to-date.

For the full year 2023 and 2024, we maintain our S&P 500 EPS estimates of USD 215 (–2% year-over-year) and USD 235 (+9% year-over-year), respectively. Our numbers reflect a softening in the labor market later this year and some headwinds from the tighter bank lending standards. If the unemployment rate stays around current levels for the balance of the year, there could be some upside to our estimates.

While we acknowledge the more resilient economic data, the strong year-to-date market gains seem to already reflect a better outlook. For example, the S&P 500 has significantly outperformed its historical relationship with the ISM Manufacturing index.

And with the S&P 500 already trading at a P/E of almost 19.5x the consensus forward EPS estimate, we struggle to see scope for much equity market upside, especially considering that expected profit growth is only 6%, much lower than the solid double-digit profit growth expectations during prior periods of lofty valuations.

To be fair, the forward P/E is a more reasonable 16.7x if we exclude the seven mega-cap tech companies (Alphabet, Amazon, Apple, Meta, Microsoft, Nvidia, and Tesla) that have driven about 75% of the S&P 500 return this year. This underscores our point that we see more compelling opportunities outside of mega-cap tech.

In sum, we look for a good results season, but after such a strong period of equity market performance that has exceeded fundamentals and pushed valuations to lofty levels, we think some consolidation of market gains is likely. Our June 2024 S&P 500 price target is 4,400. Within sectors, we continue to prefer consumer staples, energy, and industrials. We have a preference for value stocks and are neutral across size segments.

Main contributors: Authors: David Lefkowitz, Nadia Lovell, Matthew Tormey

Full report: S&P 500 EPS: What's the bar?, 14 July 2023.