Do fundamentals still matter?

Bottom Line

Equity-market fundamentals for the just-completed first quarter were extremely challenging for several reasons. First, fourth-quarter corporate earnings, most of which were reported during the second half of January and the first half of February, declined year-over-year (y/y) for the first time since the pandemic. Next, although inflation clearly peaked last year, it remains elevated and persistent, prompting the Federal Reserve to continue hiking interest rates, which it did by a quarter point at its last two policy-setting meetings.

Finally, two of the three largest bank failures in U.S. history happened. The forced closures of Silicon Valley Bank and Signature Bank and the shotgun merger between Credit Suisse and UBS are likely to lead to tighter lending standards, further pressuring economic growth and corporate profits this year.

Yet equity investors shrugged off this wave of deteriorating fundamentals and continued buying stocks. The S&P 500 rallied about 3% during March to overbought levels, extending the first-quarter’s rally to nearly 7% on a total-return basis. Since the equity market’s bottom on October 13, the S&P has extended its seasonal midterm election-year rally to more than 17%. Investors leapt back into the growthier stock sectors, such as information technology, communication services and consumer discretionary, which dramatically outperformed defensive stalwarts like energy, health care, utilities and consumer staples.

Earnings season a challenge The fourth-quarter S&P reporting season was not good. Revenues rose about 6% in the fourth quarter of 2022, but this was largely in line with inflation. By comparison, revenues rose by 16% year-over-year (y/y) in the fourth quarter of 2021. 

Earnings declined -4.2% in the fourth quarter of 2022, due to elevated inflation, rising interest rates and slimmer profit margins. In sharp contrast, earnings in the fourth quarter of 2021 rose nearly 31% y/y. This is the first annual decline in profits since the third quarter of 2020, during the height of the pandemic. 

Profit margins declined by about -10% in the fourth quarter of 2022, marking the fourth consecutive fall in profit margins. Elevated costs for labor, commodities, transportation and warehousing have contributed to the declining profitability.

How bad will first quarter results be? S&P revenues in the first quarter of 2023 are expected to rise a modest 1.9% y/y, down from an estimated increase of 3.4% on Dec. 31. That compares with a strong 13.9% y/y increase in the first quarter of 2022. This would mark the weakest revenue growth rate since a -1.1% y/y decline in the third quarter of 2020. 

S&P earnings in the first quarter of 2023 are expected to decline by -6.6% y/y, down sharply from an estimated decline of only -0.3% y/y at the end of last year. By comparison, earnings in the first quarter of 2022 rose by a solid 10.3% y/y. This would mark the largest earnings decline since the -31.8% y/y decline in the second quarter of 2020. About 20% of S&P 500 companies have issued earnings guidance on their prospective first-quarter results in recent weeks, and negative guidance has outnumbered positive guidance by a three-to-one ratio. 

That implies that profit margins will decline about -8.5% in the first quarter of 2023. 

What about the full year? FactSet reports that the consensus expects y/y earnings declines for the S&P of -6.6% and -4.4% in the first and second quarters of 2023, respectively. But it is projecting a strong rebound in the second half of this year, with estimated gains of 2.3% and 9.3% y/y in the third and fourth quarters, respectively. 

This means consensus estimates for the S&P for full-year 2023 have declined -3.8% over the past three months, from $230 to $221.50, only 1.2% higher than 2022’s actual earnings of $218.95. Last fall, we reduced our outlook for earnings from $230 to $200 in 2023 versus $208.26 in 2021 and our then-forecast for $220 in 2022. So our estimate is about 10% below the consensus. That delta, in our view, is not yet priced into stocks. 

Back-end loaded years usually fraught with peril In our view, first-quarter GDP growth could represent the high-water mark for the U.S. economy this year, as we are forecasting negative prints in the third and fourth quarter. This is due to the economic impact from sticky inflation and possibly another pair of quarter-point rate hikes into midyear, at which point we believe the Fed will pause into 2024. Tighter bank lending could exacerbate this negative trend. 

Keep playing defense The S&P has performed well over the past six months, with growth stocks smoking value. But we advise keeping the defense on the field. We’re entering a potentially challenging first-quarter earnings season. The banks will lead off on April 14, and we expect an increase in loan-loss reserves and cautious guidance. Tech stocks will follow, and we’re expecting downbeat guidance related to their slower revenue and profit growth, not to mention sizable employee layoffs as they attempt to right-size. We’re still expecting the Fed to hike rates again on May 3 and June 14. Hunker down and look to preserve capital until we gain some clarity on these uncertain issues, including the debt-ceiling debate. Another equity-market rotation from growth into defensive value, as we experienced during the first nine months of last year, could be at hand.