Financial Insights

Market Rallies in Advance of Gloomy Earnings Season: What Gives?

If you weren’t already confused by talk of impending economic doom amidst one of the strongest labor markets in history, you might now be baffled by the S&P 500’s 7.8% rally this year as we are about to hear that earnings for the first quarter have likely dropped the most (down 8%) since the depths of the COVID-sparked decline in 2020. Unraveling the mystery of this seeming contradiction lies in understanding the headwinds behind last year’s market decline, the sources of last quarter’s earnings drop, and the opportunities ahead.

The S&P 500 has been powered higher this year by Information Technology and Communications Services sectors which also pushed the tech-heavy Nasdaq up 15.8% to date. This surge occurred, in part, because stocks in those areas were the ones that dropped the most from late 2021 through late 2022. During that time, investors expected rising interest rates to erode the (present) value of future earnings growth and also began to fear that high inflation and a coming recession would undermine consumer spending. Added to those concerns was the outbreak of war in Europe in early 2022 that further crimped supplies of some key industrial inputs, reduced food supplies, increased energy costs, and drove defense spending higher. Beyond those broad macroeconomic issues, investors recognized that companies that saw sales surge during the pandemic (e.g., in PCs, smartphones) would now see consumers shift spending elsewhere (e.g., travel and leisure).

All of those concerns were legitimate, particularly for investors with a relatively short investment horizon. But as the end of 2022 approached, investors began to see that most of the interest rate increases were now in the rearview mirror and so a major headwind for stock valuations would not only abate, but could become a tailwind within the next several quarters. In addition, it appears that the pandemic darlings would see the worst of the sales declines this quarter or next, and investors began looking beyond this to recovery in the second half or in 2024. Investors did not want to miss the appreciation that would match such improvements. The S&P 500 has climbed 16% since its mid-October trough and much of that was driven by the Index’s largest companies, Apple (up 19%) and Microsoft (up 27%), for which above-average earnings growth is expected to continue for several years.

But earnings season is upon us and investors have begun to question whether that rally can be sustained. Several large money center banks reported on Friday and investors breathed a sigh of relief. Not only were profits better than expected, these banks raised their guidance for the balance of the year. We have yet to hear from the regional banks, but signs are accumulating that banking stresses are abating. Deposit outflows have slowed and use of the emergency lending facility has already dropped substantially.

We are, however, expecting that the slowdown in manufacturing activity will eat into sales forecasts for many companies. We are also coming off peak profit margins as price increases slow and wages continue to rise. As companies try to protect their margins, we are likely to see more layoffs and that could undermine consumer spending, which to date has remained more resilient than many expected. Corporate spending on new factory capacity is also showing signs of weakening. Some of this may reflect a reversal of overbuilding during the pandemic, but some may be in anticipation of broadly weaker household income growth. In addition, banks have become more stringent in their lending standards, so reduced loans to consumers and firms may also crimp growth. The extent of this tightening of liquidity has yet to be fully revealed. We should expect management teams to offer cautious guidance for this quarter and this year, because of the growing signs of slower economic activity and higher recession risks.  Yet even with all of this, growth has remained resilient.  Can it be sustained?

The Fed’s objective is to slow growth to contain inflation, but they could overshoot to the downside. Yet, even if we do end up in recession, recessions are temporary. The U.S. economy still has among the most adaptable engines of innovation in the world, the capacity to efficiently deploy capital, and the educational system to develop the human capital required for growth. And as we’ve seen for the tech stocks, investors have the capacity to look beyond even a steep drop in sales and profits to better times ahead. Remember that when COVID struck, the S&P 500 dropped over 30% from February 19th through March 23rd 2020. But it had fully recovered by late August 2020, and that was well in advance of seeing the light at the end of the tunnel from a vaccine’s development.  As the Oracle of Omaha famously quipped, investors should be “fearful when others are greedy, and greedy when others are fearful.” We cannot know whether the rally to date will carry on through the year, but we can continue to position portfolios for those risks and to take advantage of the opportunities ahead.

The foregoing content reflects the opinions of Advisors Capital Management, LLC and is subject to change at any time without notice. Content provided herein is for informational purposes only and should not be used or construed as investment advice or a recommendation regarding the purchase or sale of any security. There is no guarantee that the statements, opinions or forecasts provided herein will prove to be correct. Past performance may not be indicative of future results. Indices are not available for direct investment. Any investor who attempts to mimic the performance of an index would incur fees and expenses which would reduce returns. Securities investing involves risk, including the potential for loss of principal. There is no assurance that any investment plan or strategy will be successful.

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