Weekly Update

What if Corporate Earnings Have Already Hit Bottom?

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Published July 21, 2023

The stock market has been embracing the idea of a “soft landing” whereby the Federal Reserve is able to bring interest rates back to normal levels without hurting the economy. The market also believes that corporate earnings are likely to be at their weakest in the current reports of second quarter activity. If that’s true, what happens after periods of weak corporate earnings? Fidelity recently published a report answering that question and showing how the current period of under-performance from small cap stocks can play out going forward. Here’s Fidelity analyst Denise Chisholm’s analysis:

“The COVID-19-era profit recovery ended more than a year ago: Aggregate earnings among S&P 500 companies fell over the three- and 12-month periods through March, putting year-over-year earnings growth in the bottom quartile of its range since the early 1960s. Historically, earnings downturns have signaled opportunity for investors. Since 1962, the S&P 500 has had an 11% average return during the 12 months after bottom-quartile last-12-month earnings growth—higher than the index’s average returns following all other earnings-growth quartiles (Exhibit 1).

Stocks had stronger returns after weaker earnings growth

Earnings could weaken further, but that may not drag down stocks: After earnings downturns, the stock market historically started recovering two to three quarters before earnings did, on average.

After Poor Earnings, Cyclicals Typically Led

Cyclical sectors tended to outperform for the 12 months following bottom-quartile 12-month earnings growth, beating the market 57% of the time, compared with 41% for defensives. Within cyclicals, consumer discretionary stood out, outperforming the market more than two-thirds of the time in the 12 months following bottom-quartile year-over-year earnings growth (Exhibit 2)

Cyclicals had better odds after weak earnings

The Small Cap Market Looks Scared

Valuation spreads—the difference in valuation between the cheapest and most expensive groups of stocks—have been a gauge of investor fear. Within small caps, valuation spreads based on book yields were at historical extremes at the end of April, reaching the widest 5% of their range since 1990 (Exhibit 3). Historically, these levels signaled opportunity. Since 1990, when book yield spreads in the small cap Russell 2000 Index reached their top 5%, the index posted a 46% average return over the next 12 months.

High small cap valuation spreads suggest investor fear

Cheapness Relative to Large Caps Positioned Small Caps to Outperform

Small caps looked unusually inexpensive relative to large caps as of the end of April, based on book yield. Since 1990, the only time small caps were cheaper compared with large caps was in the early days of the pandemic. Historically, the cheaper the Russell 2000 was relative to the S&P 500 on book yield, the more likely the small cap index was to outperform its large-cap cousin over the next 12 months (Exhibit 4). This analysis, in addition to my other recent research, gives me a positive outlook for stocks—especially cyclical sectors and small caps.”

Small caps outperformed after cheap relative valuations


Market Update

A positive Monday session kicked off a week heavy with corporate earnings. Stocks shrugged off weak reports on the Chinese economy to add +0.4% with bank shares continuing to respond well to earnings reports from Friday. Another raft of bank earnings propelled stocks +0.7% higher Tuesday. Bank of America, Schwab, and Morgan Stanley all pleased investors with their reports. The Schwab report sent shares of the company flying +13% as deposits held up better than feared. Investors have held down shares of regional banks after the February crisis in Silicon Valley Bank led to widespread fears that deposits would leave smaller banks. Adding to the upside Tuesday were comments from Microsoft on how AI would impact future products and pricing. Investors cheered the plans sending shares higher +4%. Another +0.2% hike in the S&P 500 Wednesday, once again fueled by regional banks recovering from the first quarter’s steep selloff. A split market Thursday found megacap tech stocks encountering their first day of real selling in weeks. The Nasdaq tumbled -2% on weakness from Tesla, Taiwan Semiconductor, and Netflix. Netflix and Taiwan Semi’s results disappointed while Tesla chief Elon Musk hinted at future price cuts for the electric car maker. However, defensive sectors saw heavy buying, in part on a strong report from Johnson & Johnson. The jump in JNJ’s shares helped the Dow Industrials to their 9th straight gain; it is the index’s longest winning streak in six years. That streak added a 10th day Friday with the Dow just above breakeven while other market indexes slipped. Healthcare and utility stocks posted another day of solid gains. The broadening of the market rally and rotation into financial and healthcare sectors adds to the overall strength of the rally.

Stocks saw significant rotation this week with non-tech stocks pushing the S&P 500 higher by +0.65% while the Nasdaq 100 (QQQ) fell -0.91%. Smallcap stocks rose +1.53% on the week.

Warm wishes and until next week.