• Q3 financial results put an end to the earnings contraction streak

• Profit margins improve but real revenue suffers

• US indices look expensive as markets price in the perfect scenario

Solid earnings season with some asterisks

As the vast majority of US companies have revealed their Q3 financials, it is safe to draw some conclusions about the health of the corporate world. Firstly, the results have been quite encouraging, with the S&P 500 posting a 6.6% annual earnings increase according to IBES after three consecutive quarters of negative growth. This topline outperformance has been enough to propel major US indices higher with a little help from the improving macro landscape.

However, Q3 revenue growth for the S&P 500 is currently standing at 1.4% year-on-year, while if we account for the inflation rate running at least above 3.5% during the same period, real revenue has been negative. Hence, it is clear that sales are shrinking as consumers are starting to feel the heat of high interest rates, but until now corporations have been able to defend or even widen their profit margins. Given that revenue, compared to earnings, is less susceptible to accounting tricks, these quarterly results could suggest that earnings are increasing but earnings’ quality is actually falling.

Forward estimates might be overly optimistic

This cheerful earnings season has prompted analysts to upgrade their profit forecasts, pricing in a perfect scenario where inflation slows without causing significant damage to the growth outlook. But don’t forget that the US economy grew by a staggering 4.9% annualized pace in Q3 and it is highly unlikely that it can print similar numbers moving forward. The Fed itself has said that some period of below-trend economic growth is needed to get inflation back down to the 2% target, thus the previous quarter is just a positive outlier and probably not representative of what comes next.

Meanwhile, even though interest rates have most probably reached their terminal levels, their lagging impact on the economy suggests that it could take more than 12 months for their full effect to be felt. In brief, it seems that the numbers do not really add up as earnings growth is anticipated to reaccelerate in a period of global economic slowdown and high interest rates. This divergence opens the door for a significant correction if profit growth does not live up to its expectations.

Valuations are still stretched

The softer-than-expected employment and inflation reports for October coupled with an overall upbeat earnings season have been the main drivers behind the latest rally in stock markets. This advance has propelled the major US indices to ‘expensive’ levels not from a price perspective but relative to the value they are offering.

Currently, the S&P 500 is trading at 18.7 times what analysts project earnings to be over the next twelve months. That’s under the assumption that earnings are going to grow 11.2% in 2024, while fiscal and monetary conditions are expected to remain tight.

As we can see from the chart, the forward Price-to-Earnings (P/E) ratios for both the Nasdaq and S&P 500 are above their 10-year rolling averages, which largely incorporate a period characterised by QE and extremely low interest rates. That essentially means that markets have already discounted a ‘soft’ landing as the base case scenario, neglecting the probability that something could crack in the economy due to interest rates remaining elevated for a protracted period.

All in all, it is likely that the economy manages to dodge a severe recession or a systemic incident, but the fact that stock markets are priced for perfection leaves little room for errors.