Q1 Earnings Season Takeaways

Q1 earnings season is winding down and the 428 S&P 500 companies reporting results so far indicate aggregate income is likely to drop slightly year over year, following Q4’s contraction. Still, this tops pessimistic expectations overall. In our view, stocks’ decline last year likely pre-priced this dip. Seeing the actual decline—and how shallow it is—should quell uncertainty and help them move on.

Blended earnings, which combine actual results and remaining estimates, have fallen -2.2% y/y, better than the -6.7% the consensus expected at Q1’s end.^[i] Of the companies reporting, 79% beat estimates, above the one-year average of 73% and the five-year average of 77%. Except for Utilities, all sectors have topped analysts’ estimates. Meanwhile, sales have beaten across the board with the S&P 500’s Q1 blended revenue growth hitting 3.9% y/y versus the 1.9% expected at quarter close. Exhibit 1 shows what this looks like: Trailing four-quarter sales continued to make new highs in Q1—normal outside of recessions—while trailing four-quarter earnings have pulled back a bit amid higher costs.

Exhibit 1: Earnings Have Pulled Back Some, but Sales Going Strong

Source: FactSet, as of 5/4/2023.

With revenues growing and costs the main driver of earnings’ decline, a return to growth may hinge on cost-cutting. There is some preliminary evidence of this process starting to have an effect, even if it doesn’t yet show in headline data. Net profit margins—what is left after all expenses (production costs, but also tax, interest, marketing and administrative overhead) as a percentage of sales—edged up to 11.5% in Q1 from Q4’s 11.3%, their first increase in six quarters. (Exhibit 2)

Exhibit 2: Profit Margins Showing Signs of Stabilizing

Source: FactSet, as of 5/4/2023.

While only one measure of corporate profitability, improving net margins show more revenue is filtering through to the bottom line—and investors. Now, one quarter doesn’t make a trend. But note, although profit margins are off their peak, they remain above any point pre-pandemic—Corporate America’s profitability is still quite substantial. Yet headlines overlook it, suggesting some stealthy surprise power lingers.

Of course, entering May, Q1 is rather backward looking, particularly for markets focused on the 3 – 30 month outlook. Analysts expect Q2 earnings to keep falling year over year, which would be three straight quarterly contractions if Q1’s drop holds. Yet the S&P 500 has risen 14.6% from October 12’s low, which strongly suggests to us stocks have moved on and are looking forward to second-half growth and beyond.^[ii] After bear markets, stocks typically recover well before earnings.

Apparently sensing better times ahead, corporations’ Q1 earnings calls have seemed less downbeat, too. According to one compilation, about 40% of calls so far have mentioned recession versus near 60% in Q2 last year.^[iii] We see this as indicative of sentiment more than anything—executives aren’t necessarily more prescient than anyone else. Just because they appear less concerned doesn’t mean everything is going to be ok—all it reflects is their mood today. But as a sentiment gauge, we think it shows recession fears’ grip may be starting to loosen.

We don’t know yet if October’s low will mark stocks’ bull market recovery, but it looks increasingly like it to us. A tall wall of worry remains for markets to climb, leaving plenty of room for reality to exceed expectations and send stocks higher.