This article first appeared in the Morning Brief. Get the Morning Brief sent directly to your inbox every Monday to Friday by 6:30 a.m. ET. Subscribe
Friday, August 12, 2022
Second-quarter earnings season is winding down, so we have a decent picture of what went right and wrong in Corporate America during the second three-month stretch of the year.
In the aggregate, things appear to be pretty good. But look just a little bit closer, and the shine starts to come off this outlook.
In a vacuum, mid-single digit earnings growth is roughly in line with the average rate of earnings growth over the last 20 years — suggesting the second quarter was a fairly typical period for America’s largest businesses. No quarter, of course, exists in a vacuum, and few periods have been as eventful for investors as the second quarter of 2022 turned out to be.
Six of the S&P 500’s 11 sectors have reported positive earnings growth in the quarter. But if we take energy out of the equation, the second quarter is a bit more dodgy.
In fact, this growth rate of 6.7% would flip to a decline of 3.7% if energy were excluded from the index.
And energy holds just a 4.4% weight in the S&P 500.
FactSet notes that Exxon (XOM) and Chevron (CVX) together account for nearly half — 44% — of the energy earnings growth seen during the quarter, earning a combined $20.9 billion more than during the prior year period. Profits accruing to the energy sector in the second quarter were $47.7 billion higher than last year; the balance of the S&P 500 has so far earned $31.1 billion more than in the second quarter of 2021. All told, earnings in the energy sector rose 299% from the prior year in Q2.
By the end of Q2, the S&P 500 was sitting in a bear market and had suffered its worst first six months to a year since 1970. The Nasdaq endured its worst opening six months on record.
During the quarter’s final month, the price of gas exceeded $5 a gallon nationally for the first time. In June, consumer prices rose 9.1% from the prior year, the most since 1981. Gas prices, of course, help explain much of the boost to energy profitability during the quarter — the price of WTI crude oil traded north of $100 a barrel for most of the second quarter, up from a price in the mid-$60s the prior year.
Just six weeks later, we can see how much has changed for investors.
The Nasdaq is up 20% from its lows. The price of gas is below $4 a gallon nationally. Inflation pressures have shown very preliminary signs of easing. And this Q2 drop in corporate profits also, in part, explains the market’s recent rally.
As Keith Lerner, chief market strategist at Truist, noted Thursday, the S&P 500’s P/E ratio has expanded from a low of 15.3 in mid-June to around 17.5 today.
A simple way to view the P/E ratio is how much investors are willing to pay for a dollar of earnings. When P/E ratios go up, it suggests investors believe future profits will be higher than current profits; when the P/E ratio falls, it suggests the opposite.
One interpretation of the recent rally in stocks, then, is that investors think the worst is over for this recent contraction in corporate profits.
The problem with this argument? Earnings estimates for the S&P 500 are trending lower.
That creates a head-scratching situation for markets as we head into the final few months of the year.
“The entire rally witnessed since mid-June has been driven by valuation expansion,” Lerner said Thursday. “This increase was partly based on hope of a Fed pivot to a less aggressive policy stance and a sharp pullback in the 10-year U.S. Treasury yield. Such a pivot seems less likely near term given the very strong employment report from last week.”
A week ago, we learned the U.S. economy added 528,000 jobs in July, not exactly the kind of data that calls out for the Fed to change course on raising interest rates.
All else equal, lower interest rates make stocks more attractive and easier Fed policy means lower future interest rates — a textbook setup for stocks.
Declining earnings growth, however, would suggest just the opposite and challenges the case for higher stock prices.
In Lerner’s view, the balance of risks indicates an earnings slowdown will win out over hopes for the Fed to change course. “We reiterate our view that this is a more reasonable place for investors who are over-allocated to equities to trim exposure,” Lerner said.
And the recent slide in oil prices suggests energy won’t be able to save the day in the quarters ahead.
What to Watch Today
8:30 a.m. ET: Import Price Index, month-over-month, July (-0.9% expected, 0.2% during prior month)
8:30 a.m. ET: Import Price Index excluding petroleum, month-over-month, July (-0.4% during prior month)
8:30 a.m. ET: Import Price Index, year-over-year, July (9.5% expected, 10.7% during prior month)
8:30 a.m. ET: Export Price Index, month-over-month, July (-1.0% expected, 0.7% during prior month)
8:30 a.m. ET: Export Price Index, year-over-year, March (18.2% during prior month)
10:00 a.m. ET: University of Michigan Consumer Sentiment, August preliminary (52.4 expected, 51.5 during prior month)
10:00 a.m. ET: U. of Mich. Current Conditions, August preliminary (57.5 expected, 58.1 during prior month)
10:00 a.m. ET: U. of Mich. Expectations, August preliminary (48.8 expected, 47.3 during prior month)
10:00 a.m. ET: U. of Mich. 1 Year Inflation, August preliminary (5.1% expected, 5.2% during prior month)
10:00 a.m. ET: U. of Mich. 5-10 year Inflation, August preliminary (2.8% expected, 2.8% during prior month)