Market Commentary

• Investors are wondering why such a high percentage of companies consistently beat earnings expectations.
• We think consensus expectations are a bit optimistic and second quarter results might illustrate that view.

Let’s face it, earnings-season results typically show that 65% to 70% of companies beat their consensus earnings expectation. That has been the typical trend for many years, but there have been a number of quarters since the pandemic where the beat rate came in at 75% to 80%. Some of our regular readers may be wondering why such a high percentage of companies seems to consistently post results that are better than the market expects.

Much of the answer lies in the guidance that companies issue to the research analysts that are covering them and making buy, sell, or hold recommendations on their stocks. Many companies avoid being overly aggressive on revenue and profit estimates as they would rather “under promise and over deliver.” Beating consensus revenue and earnings estimates tends to be a positive for stock prices, even though most market participants are well aware that chief financial officers (CFOs) are not going to go too far out on a limb when issuing guidance on anticipated results, even if they have a very optimistic outlook. So conservative guidance has become the norm on Wall Street.

Of course, transition times in the economic cycle can be tricky for economists and CFOs. When the economy enters a slowdown or when growth improves as the economy rebounds from a rough patch, the potential for an earnings surprise, up or down, relative to consensus increases. Will the second quarter offer the potential for a surprise that could impact the overall stock market? There will always be companies in each earnings season that meaningfully beat or fall short of expected results. But what about for the S&P 500 Index (SPX) as a whole?

Right now, according to Bloomberg data, the consensus estimate is calling for a robust 8.1% earnings year-over-year growth rate for the SPX in the second quarter, even as the economy continues to slow. Earnings reporting season starts in earnest late this week. Investors need to realize that earnings growth has been concentrated in a relatively small number of tech and tech-related companies in recent quarters, just as the bulk of the SPX gains this year has been carried on the shoulders of a handful of these same companies. Broad earnings strength has not been a characteristic of this rising stock market. For example, second-quarter consensus estimates have 4 of 11 S&P sectors posting negative (contracting) year-over-year earnings results. In the first quarter of this year, three sectors showed earnings contractions greater than 20% relative to the year-ago period. This is not a scenario where the rising tide is lifting all boats.

But realize that earnings represent only what happened in the recent past. What is important for investors is what is going to occur down the road. We think consensus expectations might be a bit optimistic. Our strategy continues to be one of more conservative positioning while expecting increased market volatility that in our view will present opportunities in coming quarters.

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