What Q2 Earnings Imply for Market Valuation and Performance

07.26.2023 Investors have been ensconced in a full-blown earnings contraction that began in Q4/22, resulting from a challenging blend of higher interest rates, wages and other input costs. Despite the difficult profit environment, they continue to push up US equities. And their buying interest hasn’t been confined only to consumer staples – Q2/23 returns exceeded profit growth expectations for every economic sector group. One striking example: energy lost less than one per cent last quarter even though analysts anticipate sector profits to be slightly more than half of what they were last year. With market valuations stretched, what should investors be focusing on now?

Q2/23 YoY Earnings Growth Expectations vs Q2 Returns

With about half of S&P 500 companies having reported so far, nearly 80 per cent have beaten their profit expectations – slightly higher than median – while only about half exceeded their revenue targets.  That’s disappointing, given that in a typical quarter 60 per cent outpace their top-line expectations. This suggests the quality of earnings reported is not high, since it’s much harder to massage the top line than it is to fiddle with the bottom line. Comparing the current reported earnings (GAAP) multiple, subject to adjustments, to the cash flow multiple, typically unadulterated, confirms our suspicion – although earnings quality has been deteriorating for the last decade.

GAAP Multiple Minus Cash Flow Multiple

Notwithstanding anticipated 15 per cent profit growth over the next four quarters, the S&P 500 is over its skis by about 11 per cent This is based on the assumption that, adjusted for interest rates, the S&P’s total return should track profit and dividend growth over time. The difference in forward P/Es between the capitalization-weighted index and the equal-weighted index is as wide as it’s been since our tracking began in 2009, suggesting the largest companies account for most of the Index’s overvaluation.

Only two times in recent memory did the cap-weighted index outpace the equal-weighted index by more than ten percentage points over a trailing three-month period: 2000, during the tech bubble; and 2020, during the height of the pandemic lockdown. In both cases, the equal-weighted index caught up to the S&P 500. Beginning in June 2020, the equal-weight index rose more than 50 percentage points over the subsequent 12 months, outpacing its cap-weighted counterpart by nearly 10 percentage points. The S&P equal-weight trailed the S&P 500 by ten percentage points over the first three months of 2000, only to snap back over the subsequent year, rising a little more than four percent while the cap-weighted index plunged by more than 20 percent during that timeframe.

Bottom Line:  The market’s valuation is stretched and, in our view, simply meeting profit expectations will likely not be enough to keep the largest stocks afloat. However, the average stock is more reasonably priced, suggesting a diversified portfolio is positioned to outperform the Index over the next four quarters if history is a guide. We recommend owning quality companies with persistent dividend growth as investors reconcile fundamentals with valuation.

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