- Earnings for Q3 were slightly better than expected.
- The roller coaster in bond yields affected stocks during October and November, in our view.
- We think bond yields have peaked and so we remain optimistic.
“If a tree falls in the forest and no one is around to hear it, does it make a noise?”
This common (and frankly overdone) philosophical question asks one to consider the difference between an event and our perception of that event. Each quarter, equity investors must experience a more tangible version of this same exercise: earnings season. With each company that reports earnings, the numbers and management comments are an event that is important, but perhaps more important is how the market perceives these events. RiverFront’s investment team uses “bottom-up” analysis to digest each company’s earnings (our proverbial 'tree falling'), but this analysis alone only paints half a picture. “Top down” analysis, or viewing markets from a macroeconomic view, provides RiverFront with a fuller context of the 'forest’.
Looking at Q3 2023 earnings, we believe that companies largely painted a picture of guarded optimism based on their earnings and guidance. However, what investors initially heard were concerns about an interest rate-led recession taking a toll on longer term earnings, evident by the market weakness we saw in October. Markets then rebounded strongly in November driven largely by the decline in bond yields. Stable earnings and falling yields have been a good combination for stocks, in our view.
Companies Reported Better Than Expected Earnings Growth in Q3
At RiverFront, we use 3 ‘earnings principles’ (detailed here in our 9/12/23 strategic view) to create a framework for “Bottom-Up” analysis. Applying this framework to Q3:
- Estimates Matter: There are 2 positive messages from Analysts this quarter, in our view. The first is that 2023’s earnings have improved as companies reported. The other is that estimates for next year have held steady. This is actually atypical; Analysts are often too optimistic, leading to a decline in future earnings over time. This pattern was seen in both the 2023 and 2024 numbers, shown in the adjacent chart, which fell during the first half. Also worth noting is the gap between the two lines since analysts are expecting significant earnings growth in 2024. We think this is a positive signal, especially given the recession and rate concerns that are prevalent in the market.
- Surprises Matter: Across all the sectors in the S&P 500 except Energy, earnings surprises for the quarter were positive on average. Consumer discretionary, technology and communication services experienced especially strong surprises, but financials, materials and industrials were also strong. Guidance was somewhat mixed but still generally positive, as analysts are maintaining their growth expectations in the coming year.
- Trends Matter: Earnings trends are also positive. S&P 500 earnings have resumed their uptrend following the dip in 2022 (see chart, right). We think the resumption of the uptrend is especially encouraging given the recent macro backdrop of higher rates and inflation that would ordinarily be weighing earnings down. Corporate America has done a good job of navigating a difficult environment, in our view. Taking these principles together, and looking ahead to the fourth quarter, we believe earnings are painting a relatively constructive picture for US stocks.
The Magnitude of the Move in Interest Rates Overshadowed the Impact of Earnings
What we think was extraordinary about the earnings season was the outsized importance that interest rates played on the market reactions. Looking at the chart below, we can see how 10-year bond yields (note the inverted scale) moved in lockstep with stocks. The reversal in 10-year Treasury yields in November (orange line in the chart) was the major catalyst for the rebound in the S&P 500. In our view, the influence of bond yields was unusually strong because the move in yields was so dramatic. In general, the relationship between stocks and bond yields makes sense to us for two reasons. First, uncertainty around the economic impact of higher rates often leads to some contraction in PE multiples (as happened in October) and thus the relieving of that concern to the recovery in November. Second, the level of yields can determine where investors put their money. Over the past decade, low rates forced investors into equities, a tailwind that is no longer present since current yield levels, though lower in November, are still high by the standard of the last 10 years.
Portfolio Conclusions: We Remain Overweight US Stocks
From a portfolio perspective, we continue to favor stocks over bonds, reflecting a growing optimism about earnings and a cautious optimism about the recent decline in interest rates. While we believe the decline in rates might have been too sharp and too fast, we also believe that declining inflation is making higher rates (6% or higher) less likely. These two beliefs form our base case that bond yields have likely peaked.
What we believe is critical for our investment selections is to continue to focus on sectors and stocks where growth is evident, such as mega-cap technology, and sectors with valuations that are less stretched, such as energy. As always, we stand ready to risk-manage should earnings or the economy take a turn for the worse.
Risk Discussion: All investments in securities, including the strategies discussed above, include a risk of loss of principal (invested amount) and any profits that have not been realized. Markets fluctuate substantially over time and have experienced increased volatility in recent years due to global and domestic economic events. Performance of any investment is not guaranteed. In a rising interest rate environment, the value of fixed-income securities generally declines. Diversification does not guarantee a profit or protect against a loss. Investments in international and emerging markets securities include exposure to risks such as currency fluctuations, foreign taxes and regulations, and the potential for illiquid markets and political instability. Please see the end of this publication for more disclosures.