Inflation, Rates in Focus as Earnings Roll In

Third-quarter earnings kicked off last week, giving investors an opportunity to price stocks based on something other than macroeconomic variables like inflation and interest rates.  

Reports from two of the most high-profile companies, Netflix Inc. and Tesla Inc., were a mixed bag. Netflix jumped more than 13% on the back of a report that showed better-than-expected subscriber growth, while Tesla sank 3% after it reported a revenue shortfall.  

Next week, the earnings season kicks into high gear with reports coming from Alphabet Inc. (Tuesday), Microsoft Corp. (Tuesday), Meta Platforms Inc. (Wednesday), Apple Inc. (Thursday) and Amazon.com Inc. (Thursday). Those five stocks alone make up more than a fifth of the SPDR S&P 500 ETF Trust (SPY) and other funds that track the S&P 500. 

Alphabet’s and Meta’s quarterly results will be scrutinized by investors to see whether the digital advertising market has stabilized or is still reeling. 

Microsoft’s report will offer insights into the status of the enterprise software market. Amazon’s cloud computing division will provide color on tech spending, and the performance of its e-commerce business will provide signals about retail.  

Clues about the health of global consumer demand and supply chains will come from Apple, the world’s largest publicly traded company. So far, 7% of S&P 500 companies have reported earnings this quarter, according to FactSet, and of those, 69% have topped analyst estimates. That’s less than the five-year average beat rate of 77%.  

At the same time, the rate of growth in third-quarter earnings compared with the same period a year ago is tracking at 1.6%—the slowest pace since the third quarter of 2020.  

That’s below the 8.5% growth in revenues, suggesting profit margins are narrowing.  

Earnings/Price Relationship  

As usual, the third-quarter’s earnings growth is uneven across sectors. The energy sector is expected to grow its profits at the fastest rate, followed by industrials, while financials, communication services and materials are expected to see the slowest growth, according to data from FactSet. In fact, profits at firms within those sectors may actually decline, according to analyst estimates provided by FactSet.  

Earnings power the equity market; long term, the ultimate driver of share price is cold hard profit.  

Short term, that relationship doesn’t always hold. Multiples—the amount investors are willing to pay for a given amount of earnings—can rise and fall for many reasons, and that movement often overwhelms changes in profits. 

This year, energy is by far the best-performing sector in the stock market, with a 58% gain for the Energy Select Sector SPDR Fund (XLE). But while energy stocks have responded to the rise in energy profits, the same can’t be said for other sectors.  

For instance, the information technology sector is down more than 28% this year despite an anticipated 6% growth in earnings for the sector. Similarly, profits for industrial companies are forecast to rise nearly 30% this year, but the sector is down by 16%.  

A number of reasons may explain why a stock’s performance is disconnected from earnings increases in the short term: Growth may be priced in; investors don’t anticipate expansion to last; investors may not be willing to pay for the growth due to various factors.  

In the case of high-growth technology stocks, rising interest rates are cutting the value of future earnings, dampening the multiples that investors are willing to ascribe to those businesses.  

So, yes, over the long term, earnings are the primary driver of stocks, but that says nothing about the short term.  

For a snapshot of sector and earnings performance for 2022, see the table below: 

*FactSet estimates

Follow Sumit Roy on Twitter @sumitroy2