This week marks the beginning of a high-stakes corporate earnings season, with optimistic investors eagerly anticipating results that will validate the increasingly high valuations in a US stock market that is hovering near record levels. The case for robust US economic growth received a significant boost on Friday, as labor market data far exceeded expectations. Despite recent turbulence caused by escalating geopolitical tensions in the Middle East, the S&P 500 has surged by 20 per cent year-to-date and remains close to its all-time highs.
The upcoming corporate earnings will serve as a crucial test for the ongoing rally. Companies must demonstrate healthy profit growth and a strong outlook for the next year to sustain the valuations that have risen steadily in recent months. According to LSEG Datastream, the S&P 500 is currently trading at 21.5 times future 12-month earnings estimates, which is near its highest level in three years and significantly above its long-term average of 15.7.
"One of the few justifications the bulls can offer for these elevated valuation multiples is that earnings growth continues to remain at high levels," commented Sameer Samana, senior global market strategist at Wells Fargo Investment Institute. "With prices having surged, it is imperative that earnings growth exceeds expectations by a considerable margin."
UBS equity strategists anticipate that S&P 500 earnings will have increased by 4.7 per cent in the third quarter compared to the previous year. However, when considering the historical rate of positive earnings surprises, earnings are likely to have grown by 8.5 per cent. Such robust profit beats may be necessary to drive further gains in the stock market.
Since 2010, the S&P 500's total return has closely mirrored the growth in company earnings and dividends, according to Jack Ablin, chief investment officer at Cresset Capital. However, the index has outpaced expectations since early 2023, currently standing about 18 per cent above projected levels based on current earnings and dividends.
"The market is slightly ahead of itself here," Ablin noted. "It is clearly anticipating substantial earnings and dividend growth."
Next week's data on US consumer prices will provide investors with another glimpse into the economy's health. A stronger-than-expected figure, following Friday's robust jobs data, could further diminish expectations for the extent of Federal Reserve rate cuts in the coming months.
Futures linked to the fed funds rate on Friday indicated a 50 basis point cut at the Fed's November meeting was priced at 5 per cent, down from over 30 per cent on Thursday, according to CME FedWatch.
Major financial firms will be in the spotlight during next week's earnings reports, with JP Morgan Chase, Wells Fargo, and BlackRock scheduled to release their results on October 11. Bank results offer valuable insights into the economy, including the state of delinquencies and loan demand, according to Bryant VanCronkhite, senior portfolio manager at Allspring Global Investments.
More broadly, VanCronkhite will be looking for signs that the Fed's initial 50-basis point cut, announced at its monetary policy meeting last month, is already impacting the economy, such as through increased auto sales and other major purchases. Ideally, such activity will persist even if expectations for further rate cuts diminish following Friday's strong jobs report.
Following the first rate cut, companies should ideally show that leading demand indicators are strengthening, VanCronkhite said. "That would likely instill confidence that we are moving towards a soft landing," he concluded.
