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Companies are just beginning to get more confident in their profit outlooks, although the stock market has a lot to sort through before it is likely to stage any substantial rally.
Still, the signs of optimism represent a positive shift. Over the past year, analysts’ average forecast for 2023 earnings from
S&P 500
companies has dropped by just over 10%, according to FactSet. That is partly because Wall Street sees a multitude of challenges, and partly because companies across the board have lowered their forecasts for profits.
There is plenty of reason to worry. The Federal Reserve’s interest-rate increases, meant to cool inflation by reducing demand for goods and services, imply companies will be able to raise prices less quickly, and will sell less of whatever they have to offer. The cost of labor is still rising, which threatens profit margins.
But fewer companies are now lowering their profit forecasts. Over the past three months, the share of S&P 500 companies that reduced their earnings guidance outstripped the portion that raised their calls by 25 percentage points, according to 22V Research. That compares with 35 points for the three months through late 2022.
Now, “the earnings outlook is looking less bleak,” wrote 22V Research’s Dennis DeBusschere in a note to clients on Thursday.
Consistent with that, analysts are cutting their earnings estimates for fewer companies. The percentage of companies for which Wall Street is raising its profit calls has risen in the past month, even though reductions still outnumber increases.
The profit picture becoming less bad is consistent with the stock market’s narrative that economic growth and profits will soon bottom and then rebound as the Fed finishes its rate-increase campaign. Expectations for that to happen have helped lift the S&P 500 by about 14% since a low point in early October.
But now, the market is priced expensively even though risks abound. The S&P 500 is trading for just over 18 times the aggregate per-share earnings its component companies are expected to produce over the next year, compared with a bit over 15 times in early October.
Those earnings are smaller relative to the cost of the index, making the yield available from holding stocks less appealing relative to what investors can get by holding safe government bonds.
The outlook for earnings is uncertain. Forecasts for profits may have nearly hit bottom, but any further reductions would make stocks look more expensive.
And the Fed may not be finished raising interest rates. The annual rate of inflation was at just over 6% in January, a far cry from the Fed’s 2% goal. Any additional rate increases the bank rolls out could mean additional pressure on economic growth and earnings.
“The Fed having to tighten much more and causing a recession is the risk to earnings,” DeBusschere wrote. “And that is what we are most worried about.”
Sometimes the market just gets ahead of itself. Buyers, be patient.
Write to Jacob Sonenshine at jacob.sonenshine@barrons.com