Why earnings season might be a “market-moving event”

With the pivotal fourth-quarter earnings season kicking off on Friday, there appears to be a tug-of-war raging on Wall Street.

On the one hand, there are those who believe expectations have already been lowered enough to provide a springboard for better-than-expected results and stock gains, while on the other side there are those who believe lackluster results and downbeat guidance forward will lead to further declines.

With the S&P 500 SPX,
Given the more than 11% rally over the past three months, the bulls seem to have the advantage. But there are also reasons to believe the bears could regain control once earnings reports start pouring in before the opening bell on Friday. A large group of major bank profits.

said Jill Dudak, chief investment analyst at Dudak Research Group, a division of Wellington Shields & Partners LLC.

Here are some factors to consider and trends to watch in earnings reports that may indicate whether bulls or bears will have the advantage.

Have EPS estimates fallen too much — perhaps enough to provide a cushion for stocks?

The current mixed growth estimate for the S&P 500 earnings per share (EPS), which includes results already reported and analyst consensus estimates for those results not yet reported, is for a decline of 4.8%, according to FactSet. This would be the first annual drop in earnings per share since the third quarter of 2020.

Although compiled earnings per share estimates are usually cut during the quarter, estimates for the fourth quarter were cut much more than historical averages amid growing fears of a recession.

The estimate for fourth-quarter gross earnings per share for S&P companies was $54.01 on Dec. 31, down 6.5% from $57.78 on Sept. 30, FactSet’s chief earnings analyst John Potters wrote in a recent research note. That compares to an average decline of 2.5% over the past five years.

A number of Wall Street strategists believe that estimates have been lowered enough that most S&P 500 companies are outperforming expectations. Keep in mind that over the past five years, 77% of S&P 500 companies have exceeded and beat EPS estimates by an average of 8.7%, according to FactSet.

The question is, will you beat enough comp, and will you win enough, for the bulls?

Brad McMillan, chief investment officer of Commonwealth Financial Network, thinks there’s a good chance the answer is yes.

“Here, the news is likely to be better than expected,” McMillan wrote in a recent research note. Earnings beat expectations in 2022, but that improvement was offset by a drop in valuations. With valuations halting their decline, improvements in corporate earnings should provide a cushion for markets in 2023 and perhaps even deliver some gains.”

2Steering 023 has already been cut a lot, but perhaps it should be cut further

As analysts cut their estimates for the fourth quarter, they usually reduce their views for next year. Over the past five years, the average decline over the fourth quarter in bottom-up EPS estimates for the coming year has been 0.2%, and over the past 10 years, the average decline has been 1.3%, according to FactSet’s Butters.

But given growing concerns about a potential recession, the bottom-up 2023 EPS estimate fell 4.4% to $230.51 as of Dec. 31, from $241.20 on Sept. 30.

While some might think this indicates a possible recession may indeed occur, Dudak does not believe this is the case.

“[I]It’s almost impossible to estimate how weak earnings will be in 2023,” Dudak writes, “given a combination of interest rate increases by the Fed and a weak consumer. But to price in a recession, the EPS estimate would need to be lowered by at least another 5 percentage points.”

“A 10% drop in corporate earnings is an ‘average’ during a recession,” she wrote.

Sales may be up, but a drop in volume could be more telling

While S&P 500 companies are expected to report lower earnings than they did last year, the current blend growth estimate for sales is 3.8%. Although this is down from the estimated 6.3% growth rate on September 30 and would be the slowest growth in two years, it is still positive at least. Or is it really?

The dollar amount of sales a company reports is a function of the number of products sold, or the volume, and the price at which the product is sold. And there is reason to believe that while sales may be showing growth, many companies may be selling fewer products.

This was the case for two of the first S&P 500 reporters.

Conagra Brands Inc. CAG,
With food brands including Hunt’s, Duncan Hines, Slim Jim and Birds Eye, earlier this month reported sales for the November-ending quarter that were up 8.3% from a year ago to $3.31 billion, enough to beat the FactSet consensus. by 1.1%.

This growth came despite a decrease of 8.4% in volume, because The company raised the selling price of its product by 17%..

and Lamb Weston Holdings Inc. LW, Frozen Potato Products Manufacturer,
It reported sales for the same quarter that jumped 26.8% from a year ago, beating expectations of 11.2%, according to FactSet.

But this increase was only because price mix rose 30% to make up for a 3% decrease in volume.

COGS can be a major factor, as moderation can boost margins and profits

Since inflation started to rise, one of the key items to watch on a company’s balance sheet has been the cost of goods sold (COGS), sometimes called cost of sales. This is because if cost of goods sold rises more than sales, so does gross profit margins, which means the company makes less profit on each product sold.

Gross margin is reported as a percentage. To get this percentage, you must first subtract the cost of goods sold from sales to get the gross profit. Gross margin is gross profit divided by sales.

For ConAgra, cost of goods sold rose just 3.8%, or less than half of the sales growth, to $2.39 billion. Gross margin improved to 27.8% from 24.7%.

The company’s CEO, Sean Connolly, said the relationship between sales and COGS had reached an “important inflection point” to flip the gross margin story to one of recovery from stress.

For Lamb Weston, cost of goods sold increased just 11.7%, well less than half of the sales growth, as gross profit margin expanded to 29.9% from 20.4%.

In a sign that slowing cost of goods sold growth could become a broader trend, is the latest consumer inflation data Prices showed a 0.1% decline in December, while annual inflation fell to 6.5% from 7.1%, far from a 40-year peak of 9.1% last summer.

Even if analysts didn’t cut earnings estimates enough to match How slow the economy might have been At the end of last year, a larger-than-expected decline in COGS inflation could keep the market in favor of the bulls.

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