Q3 Earnings Take Shape

With about two-thirds of S&P 500 companies reporting Q3 results, what can investors glean from them? While there were without doubt high-profile beats and misses that sent some companies’ stock prices soaring and reeling, more meaningful on a forward-looking basis, in our view, are the broader trends and what they reveal about how Corporate America is weathering this year’s storms. Scratch the surface of the overall mixed headline results, and there are strong indications that inflation, supply chain issues and other headwinds are working their way through the system. That doesn’t predict stocks, but it adds color to what markets have spent this year pricing in and suggests to us fears of much greater pain from here will likely miss the mark.

As analysts point out, earnings that exclude the Energy sector are down—not terribly much, but perhaps consistent with what this year’s mild bear market hinted at in advance. While the S&P 500’s Q3 earnings are up 3.0% y/y (combining actual results and remaining estimates), Energy’s 137.4% haul is swelling the figure.^[i] Excluding Energy, they fell -4.4% y/y, the second-straight decline after Q2’s -4.0%.

The weakest sectors were Communication Services, Financials and Materials, which are facing year-over-year earnings declines of -19.2%, -17.5% and -15.7%, respectively. Declining ad revenue appears to be Communication Services biggest detractor, while Financials’ decline is partially an accounting construct—banks’ loan loss provisioning is contributing to their earnings weakness, especially after releasing reserves last year. Commodity prices’ steep drop from a year ago seems mostly behind Materials’ profit slide. All this is backward looking, which doesn’t affect forward-looking stocks fundamentally. So we wouldn’t read into any of it as signs of worse to come for the sectors in question or the S&P 500 overall (notwithstanding base effects over the next couple of quarters). Nor do we think Energy’s jump is some massively bullish feature looking forward—it is an artefact of higher oil and gas prices.

Notably though, while sales have decelerated, they remain historically strong—and broad-based: All sectors are seeing year-over-year revenue growth. (Exhibits 1 & 2)

Exhibit 1: Sales Growth Is Decelerating, but Still Relatively Strong

Source: FactSet, as of 11/2/2022.

Exhibit 2: Positive Sector Revenue Growth Across the Board

Source: FactSet, as of 11/2/2022.

This means that, in general, earnings are largely down on costs eating into profit margins. However, we think businesses (overall and on average) having the luxury of using fat margins as a buffer to absorb more cost increases without passing them on to customers speaks to Corporate America’s better-than-appreciated resiliency. Consider: Even with this, Exhibit 3 shows profit margins remain high by historical standards. (Note: We use earnings before interest, taxes, depreciation and amortization, or EBITDA, to better aggregate companies and industries’ profitability on a like-for-like basis.)

Exhibit 3: Profit Margins Are Under Pressure, but Still Relatively High

Source: FactSet, as of 11/2/2022.

And it isn’t just because of Energy, as Exhibit 4 shows. Although most sectors have seen some compression, they have done an admirable job maintaining margins within sight of peak levels. Earnings may be down, but with S&P 500 revenue up a strong 11.0% y/y and margins holding up relatively well, profits’ two-quarter retrenchment doesn’t look disastrous. It looks shallow.

Exhibit 4: Corporate Profitability by Sector

Source: FactSet, as of 11/2/2022.

The question for stocks—and sector positioning—is what the next 3 – 30 months will bring relative to what is priced in now. Stocks, which peaked at 2022’s start, appear to have anticipated Q2 and Q3’s S&P 500 Ex. Energy earnings dip ahead of time. With the bear market going on 11 months, Energy is the only sector with positive year-to-date returns. On the other hand, Communication Services has faced the toughest sledding, with Consumer Discretionary and Real Estate not too far behind. Considering stocks move ahead of corporate earnings, it seems fair to surmise that stocks already reflect what these earnings results show.

Of course, past performance says nothing about what to expect going forward. Take Real Estate and Energy. By Q3’s backward-looking numbers, Real Estate enjoyed wide margins on top of above-average revenue growth. Yet as many folks may know, the sector faces headwinds, which markets seem to be pricing in. On the residential side, record housing units in the construction pipeline increase supply, and mortgage rates at two-decade highs limit demand. Then on the commercial front, vacancy rates remain elevated post-pandemic—rents have stagnated as a result.

Energy has benefited from substantial tailwinds—the big (and only) inflation winner this year—but will that last? Energy’s main driver—oil prices—peaked March 8. West Texas Intermediate crude has fallen -28.5% since.^[ii] Meanwhile, the US Energy Information Administration released figures on Halloween noting crude production is closing in on 12 million barrels per day. Output rose 0.9% m/m in August and 6.2% y/y to its highest level since March 2020.^[iii] (Also notable: Natural gas production hit a new record high.) Then, too, global supply has exceeded demand since July, even with OPEC’s production cuts.

As Exhibit 2 showed, Energy’s revenue growth is still running at 45% y/y, but that is almost half Q2’s rate and tied largely to base effects. We doubt triple-digit earnings growth persists. We aren’t alone. Analysts are penciling in year-over-year decline starting in Q2 next year.

Maybe commercial property resurges, driving rents higher—or oil prices rocket anew from here as demand outstrips supply—for whatever reason, say, in-office work and commutes come back in vogue. The discrepancy between current expectations and the ensuing reality might favor Real Estate and Energy. But it will be how each sector’s supply and demand fundamentals actually turn out—relative to the earnings prospects embedded in their prices—that will determine their performance moving forward. Q3 earnings don’t predict that.

Many sectors have seen earnings declines this year—to greater or lesser degree. But this is largely consistent with the market moves we have already seen year to date. This doesn’t say anything about returns ahead, but we think seeing profit downturns’ actual extent helps markets move past lingering fears.