This year, the stock market has showcased remarkable resilience, buoyed by an economy performing better than many anticipated. This positive momentum has been a boon for numerous investment portfolios, helping them to bounce back from the challenging bear market phase of the previous year. As investors look ahead, there’s growing optimism that this upward trend will bolster corporate earnings, which are traditionally aligned with market trajectories over extended periods. But in a landscape still marked by economic uncertainties, how are signs of potential profitability gains emerging for companies?
As we near the conclusion of the third quarter’s earnings season, an impressive 94% of S&P 500 companies have already disclosed their financials. Surprisingly, FactSet reports that a whopping 82% of these companies exceeded earnings expectations, heralding an anticipated 4.3% surge in year-over-year earnings-per-share growth. This upturn marks a significant milestone – the first instance of positive growth in a year, reflecting the economy’s unexpected steadiness. Wall Street’s consensus projects a static earnings scenario for this year at around $217 per share but anticipates a robust 11% jump in 2024. Although these projections somewhat contradict the forecasts for a slowing economy, any uptick in earnings will undoubtedly be a welcome development for investors.
Unraveling the Complexities of Corporate Earnings Growth
The trend in corporate earnings growth is intriguing. After reaching its zenith in 2021, there’s been a noticeable deceleration, but recent data suggest a possible turnaround. Historically, large corporations have managed to augment their earnings by about 7.7% annually, albeit with variations reflecting the economic cycle’s ebb and flow. Simplifying the earnings cycle: in prosperous times, sales outpace expenses, leading to enhanced profits and margins. Conversely, during downturns, slowing revenues compel companies to slash costs to preserve margins, setting the stage for increased profitability once economic conditions improve.
It’s a well-acknowledged fact that profits are crucial and, over extended periods, should mirror the value creation by companies. Business owners, executives, and corporate boards are invariably motivated to sustain and increase profitability, thereby enhancing shareholder returns. This emphasis on profitability is critical for investors for three key reasons.
The Stock Market's Correlation with Corporate Earnings
Primarily, the stock market’s long-term trajectory generally mirrors corporate earnings. An analysis shows that although there’s no exact alignment between S&P 500 prices and earnings, they tend to follow similar broad patterns. Economic growth fuels earnings, which in turn elevate stock prices. Hence, while the economy and stock market are distinct entities, their interconnection through corporate performance is unmistakable.
Secondly, the valuation of the stock market – whether deemed ‘cheap’ or ‘expensive’ – hinges not just on stock prices but significantly on corporate performance, particularly earnings. The price-to-earnings ratio, a crucial metric, is influenced not only by stock prices but also by earnings dynamics. This implies that even with stable prices, rising earnings can render the market more appealing, and the reverse is also true. The S&P 500 price-to-earnings ratio currently stands at 18.7 times the forecasted earnings for the next twelve months, higher than the historical average but significantly lower than the peak in 2020. This ratio will likely become even more favorable if earnings growth gains momentum.
Dividends: A Key Aspect of Investment Returns
Lastly, dividends play a pivotal role in investment returns. From a corporate standpoint, dividends are a mechanism to distribute cash to shareholders, particularly when reinvestment opportunities within the company are limited. Typically, companies aim to offer steady dividends to attract investors and, if possible, grow these payouts over time. However, it’s noteworthy that some sectors, especially within the technology realm, are known for lower dividend yields, often opting to retain more cash reserves.
For investors, dividends are an essential component of total returns. Historically, dividends, rather than price appreciation, were a primary investment motive. Today, while many investors focus predominantly on stock prices, dividends remain crucial, especially for those requiring portfolio income, such as retirees.
Despite the volatility of the market and the increase in bond yields this year, several sectors still offer attractive dividend yields. Underperforming sectors like Real Estate, Utilities, and Energy yield close to 4%. On the other hand, sectors with the most significant price appreciation, such as Communication Services, Consumer Discretionary, and Information Technology, exhibit the lowest yields. Therefore, investors should avoid making decisions based solely on recent performance or dividend yields. A diversified approach across various sectors is beneficial, particularly if earnings continue their upward trajectory.
A Focus on Long-Term Economic and Earnings Trends
The interconnectedness of economic growth, corporate earnings, and stock market performance cannot be overstated. For investors striving to achieve their financial objectives, keeping an eye on these longer is crucial.