You've Got to Earn It: Update on Earnings Season

So far this quarter, S&P 500 companies are impressing when it comes to earnings releases outpacing analysts' estimates. As of the end of last week, the earnings "beat rate" stood at a better-than-average 79%, down slightly from 79.4% in the prior quarter (of course, with the caveat that we are still somewhat early in the season). Moving up the income statement, things are less stellar in terms of the top line, as the revenue beat rate is tracking at just 59.4%. If it finishes the quarter below 59.9% (last quarter's revenue beat rate), it will be the lowest since the first quarter of 2020.

One of the interesting aspects of earnings seasons in the post-pandemic era has been the higher plateau for the earnings beat rate. In the 20 years leading up to the pandemic, the average beat rate for the S&P 500 was 67.4%; or, in other words, two-thirds of companies (on average) outpaced analysts' estimates each quarter. During the pandemic, a record number of companies (for obvious reason) pulled guidance altogether, forcing analysts to fly blind and err conservatively when assembling estimates.

Given that, the earnings bar was consistently lowered by a significant degree, sending the beat rate to a record high in 2021. While it has come down from its peak, the average has risen dramatically to nearly 79% over the past four years. This has been achieved via more significant downward revisions over time, shown in the chart below. Even if we shorten the time horizon and look since the beginning of 2023, downgrades have outpaced upgrades by a rather strong margin.

We believe the market's focus has shifted (and will continue to shift) to what's happening on the top line. Stronger earnings can only be boosted by cost cuts for so long until companies can no longer cover up weak demand. Unsurprisingly, for companies beating on both revenue and earnings this season, their outperformance relative to the S&P 500 (on average) is 2.6% the day of their reporting, the widest spread relative to misses since the end of 2018. For companies missing on both the top and bottom lines, the performance spread is -4.6%, the worst since the beginning of 2023.

With the revenue beat rate near a four-year low, the earnings beat rate remains comfortably in its higher post-pandemic average. Stronger performance for companies beating on both the top and bottom lines shows that the sales picture is becoming just as (if not more) important as the earnings picture. There are more downside risks building if the revenue backdrop doesn't firm up. Admittedly, stronger earnings beats have been enough to power the market higher; and it's unlikely that companies go back to the pre-pandemic practice of being more precise with guidance. That might keep the earnings beat rate—and the attendant excitement associated with it—higher for longer.

Widening the lens, the table below shows the progression of earnings throughout the course of this year into next year, both in the aggregate (at the bottom) and for each of the S&P 500's 11 sectors. Per the S&P 500, what's notable is the expected dip in earnings to 4.4% for the third quarter—after a stellar 13.2% earnings growth rate in the second quarter—followed by a sharp rebound to more than 11% in the fourth quarter.

The dip-to-rebound scenario from the third-to-fourth quarter is likely less about analysts actually forecasting a brief one-quarter deceleration in earnings, and likely more about analysts limiting estimate adjustments only to the nearest quarter. This is why keeping an eye on fourth quarter estimates is important as we continue through third quarter reporting season.

From a sector perspective, the winners in the third quarter are expected to be Technology and Communication Services, with the Energy sector bringing up the rear. Looking ahead to the fourth quarter, although the Technology and Communication Services sectors' growth rates remain strong, it's the Financials and Health Care sectors that come on strongest (and in the case of the latter, continue with expected strong growth next year). In terms of calendar/fiscal year growth expectations, Communication Services and Technology sit atop the leaderboard, with Energy bringing up the rear in 2024; while Health Care is expected to leapfrog Technology in 2025 and Real Estate is expected to post the lowest growth rate next year.

Per the progression of earnings estimates since the start of this year, the chart below shows all four quarters of this year and the first two quarters of next year. After a period of deceleration for all four quarters of 2024's estimates in the first few months of the year, the first quarter reporting season ended up better than expected (see the uptick in the darker blue line); which led to a pick-up in estimates for the second quarter (see the subsequent uptick in the yellow line). So far, there has only been a miniscule pick-up in third quarter "blended" estimates (combining actual reports with estimates for earnings not yet reported), shown via the green line. There is also no acceleration yet in fourth quarter estimates—or for that matter, estimates for the first two quarters of next year—shown via the red, gray and turquoise lines, respectively.

Another important shift happening this year is the relationship between the earnings growth rate of the Magnificent 7 (Mag7) group of stocks and the rest of the S&P 500. Shown below, from a stellar growth rate of more than 50% in this year's first quarter, it's expected that growth will slow to less than 20% at the end of third quarter reporting season, and remain there through the third quarter of 2025. That's in contrast to a generally improving backdrop for the earnings of the S&P 500 ex-Mag7 stocks. This remains a fundamental pillar of support for the leadership rotations that began to kick in mid-summer, when the Mag7 ceded leadership to a rotating group of sectors.

So far, so good for third quarter earnings season—at least in terms of the beat rate (relative to a significantly lowered bar). We are in the meat of the season this week, with 169 companies set to report, including five of the Mag7 group of stocks (Alphabet, Meta, Microsoft, Apple and Amazon). As much as the market focuses on the current quarter's reports, we will be keeping a close eye on forward estimates, especially for the fourth quarter of this year. It's notable that there continues to be a downward slope to estimates for the next few quarters, yet a still-lofty improvement relative to the expected dip in third quarter earnings.

We think that leadership rotations marking the performance backdrop since mid-July will likely continue. This includes rotations at times back toward the Mag7. In the first half of the year, rotations under the surface of the dominance of the Mag7 were of the negative variety; while rotations are more above the surface and positive so far in the second half of the year. We think the theme of broader, albeit rotating, participation has legs throughout the remainder of this year into next year.