Valuations or Earnings: Which is Most Important for Equity Returns in 2023?
Last year was rough for the S&P 500 Index, with investors losing almost 18% in 2022 as market valuations de-rated. With investors looking for directional insights, we believe the focus will shift in 2023 toward earnings, which we believe have peaked as economic growth declines and restrictive policy conditions continue.
- Earnings expectations have weakened this year; however, we still expect lower earnings per share (EPS) growth than consensus expectations.
- Profit margin changes are a key driver of earnings growth. We expect further margin weakness ahead.
- Our weak earnings outlook leads us to be defensively positioned in portfolios, with a preference for cash and fixed income over equities.
What story do earnings tell?
Following the COVID-19 pandemic, earnings of US companies improved for seven quarters.1 While consumer staples, health care and technology led the initial EPS recovery, it later shifted to cyclicals like industrials, materials and energy. These earnings improvements took the form of quarterly “steps” as earnings are reported quarterly (see Exhibit 1). With that said, something stands out to us that is concerning: As time has progressed, these “steps” have started to level off, meaning that the EPS growth rate has been declining. The most recent datapoint actually forms a “step-down,” representing a 40 basis-point decline in EPS growth.
Exhibit 1: Quarterly earnings—a stairway to…?
Since March 1991, the market consensus has expected positive earnings growth 74% of the time. Hence, an expected 2% EPS drop over the next 12 months is a notable signal. Weak consensus expectations have preceded historical bear markets, including the global financial crisis, the “earnings recession” of 2015/2016, and the onset of the COVID-19 pandemic (see Exhibit 2). Our leading EPS indicator, which uses leading economic and financial indicators to forecast EPS growth, suggests a 6% drop in EPS over the next year as both economic and financial indicators remain weak.2