Deep Dive video: Look for equity laggards (8:28)
CIO's Hartmut Issel on key catch-up opportunities in the second half.

Thought of the day

The US second-quarter earnings season ramps up this week against the backdrop of a more resilient economy than many—including we—expected. In particular, the job market has remained healthy, supporting consumer spending, which has also benefited from excess cash on household balance sheets and slowly rising real incomes as inflation cools. As a result, US economic data has consistently beaten expectations over the last several months, and we think the second-quarter earnings season is likely to reflect this trend.

But after a strong rally in the S&P 500 this year—the index has risen 18% year-to-date, helped by the robust economy and optimism about a handful of companies associated with artificial intelligence—we believe a lot of positive news is already priced in:

Earnings will likely beat expectations, but we still forecast a year-over-year decline. 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 second-quarter earnings per share (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 think that S&P 500 companies will once again exceed expectations. Even so, we still look for second-quarter S&P 500 EPS to decline 3–5% compared to a year ago, and think this is likely to mark the trough in year-over-year earnings growth.

While the “bar” for earnings looks beatable, the setup in the stock market itself looks somewhat different. Over the past six weeks, the S&P 500 has risen around 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 reinforce the view 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 US energy and industrial stocks. Among the more defensive sectors, we like consumer staples. We also prefer the equal-weighted S&P 500 relative to the market-capitalization-weighted S&P 500 given the high weighting of a few tech stocks in the latter, which increases both aggregate valuations and idiosyncratic risks.

Strong year-to-date gains mean broad market valuations look rich. With the S&P 500 already trading at a price-to-earnings (P/E) ratio of almost 19.5 times the consensus forward EPS estimate, we struggle to see much scope for further gains, 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 16.7 times if we exclude the seven mega-cap tech companies that have driven about 75% of the S&P 500 return this year. This underscores both the narrowness of the rally, and our view that investors can find more compelling opportunities outside mega-cap tech.

In sum, we look for a solid second-quarter results season, but after such a strong period of equity market performance, we think some consolidation of market gains is likely. For investors in US equities, we believe selectivity remains key. Read more in our recent report, “S&P 500 EPS: What’s the bar?”(PDF, 1 MB) (published 14 July 2023), and in our Weekly US Regional View(PDF, 145 KB) (17 July 2023).