Why Earnings Could Signal A Market Decline In The Months Ahead

Have you seen these headlines?

"Why the S&P 500 is poised to rock 100% in five years”

"Market rally not alarming, record highs backed by earnings growth, say analysts"

"Investors look to upcoming earnings to keep stock rally going"

If you haven't, you've probably seen some version of them. With markets hitting new highs seemingly each week, this sentiment is everywhere.

But it's dead wrong.

The argument that says earnings growth will be a key driver that pushes the market higher in the second half has a big hole in it.

Consider this: The S&P 500 saw almost zero earnings growth last year, and yet it still rallied 25%.

That means that significant earnings growth is already factored into markets. In fact, the rally pulled forward not just all of this year's earnings growth, but also the forecasted growth of the next 12 months. 

Therefore, we're going to have to see estimates rise much more significantly if it's going to fuel a further rally in the stock market.

So while markets could certainly go up from here and smash new records in the second half of 2024, it's going to take an exceptionally big increase in earnings estimates merely to justify today's level in the stock market, much less a bigger rally than we've already seen.

What Might Save This Rally

Don't get me wrong. If the market does rally further, earnings will get a lot of the credit. But that will be from analysts looking through the lens backward.

Instead, the real reason will probably be a continued influx of liquidity into the system. 

There is no guarantee that this will take place. We are already seeing signs from the decline in U.S. reserve balances at Federal Reserve banks that liquidity might be a little less plentiful going forward. 

With the Treasury General Account (TGA) flush with cash and continued fiscal spending still to consider, it's not out of the question the liquidity spigots will re-open before the summer is over.

I strongly believe that any earnings growth we see in the second half will not be enough to spur a significant rally in the second half. The catalyst will almost certainly have to come from somewhere else. 

It's true that earnings estimates for 2024 and for the next 12 months have indeed improved over the last couple of weeks. The problem is that they've only grown by 0.16% for 2024 and by 0.24% for the next 12 months!

That is not anywhere near enough to get investors excited given today's extremely high valuation levels.

Priced For Perfection?

Could these earnings estimates see a bigger jump once we get into earnings season in July? Yes, but it will take an increase of more than 20% over today's current 2024 estimates and a 25% increase in the estimates for the next 12 months to move the forward price-to-earnings (P/E) ratio on the S&P 500 down to a 17x multiple. This would still be somewhat high on a historical basis. 

Therefore, unless earnings estimates SKYROCKET going forward, earnings won't be the catalyst for a bigger rally than we've already seen this year.

We would be singing a much different song if last year's rally had not pulled forward much of this year's earnings growth. If the stock market were trading at 15x-16x earnings, I'd be much more enthusiastic about the prospects for the U.S. stock market going forward. 

Yet since it is trading at 22x forward 2024 earnings, 21x the earnings forecast of the next 12 months and 2.9x sales, we cannot put the earnings picture on the bullish side of the bull/bear ledger.

I'm not saying the situation with earnings is a negative one. Earnings are growing. It's just that the stock market has pushed too far ahead of earnings growth since the beginning of 2023 for us to be excited about today's forecasts. They're just not strong enough to push the market higher — not when the market is as expensive as it is today. 

Yes, maybe it's different this time.  Maybe the AI phenomenon will create a situation where +22x earnings is the new normal. 

We have had several extraordinary innovations over the past 100 years.  All of them were seen as something that would change the "fair value" for the stock market. 

In the end, however, none of them have achieved this goal.

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