More Earnings Estimates May Need to be Cut Before Market Bottoms

Several U.S. analysts are warning that this year’s swoon in stocks will not find a solid bottom until more company earnings estimates are cut.  Nevertheless, U.S. stock indexes have staged an impressive rally over the past six weeks on better-than-expected quarterly earnings results and on hope that the Fed will not need to be as aggressive on rate-hikes as previously feared. 

Bank of America said that its analysis of the past four recessions showed that the S&P 500 ($SPX) (SPY) bottomed only after earnings per share forecasts had fallen either to or below the level they were at when the market last peaked. While current earnings projections have fallen, they are still about 6% higher than at the time of January’s all-time high.

U.S. stocks finished July with their biggest monthly gain since 2020 as weaker economic data sparked expectations that the Fed could slow the pace of its interest rate hikes. Also, a better-than-expected corporate earnings season has bolstered speculation that profit margins are proving to be resilient to surging inflation and gloomy consumer sentiment.

A Citigroup index shows earnings downgrades are outnumbering upgrades at a level last seen at the height of the pandemic in 2020.  However, according to Morgan Stanley, the magnitude of the earnings cuts are still “modest” and are likely to extend amid concerns around economic growth, which will limit the rebound in equity markets.  Morgan Stanley said it would be “a big mistake” to assume that the market has already discounted a potential 15% to 20% decline in EPS estimates, and they expect the bulk of earnings cuts to come through only in the fourth quarter. 

JPMorgan Chase is less pessimistic and is among the few firms still having a bullish call on U.S. stocks. JPMorgan said investor expectations are likely to be reset with regards to company earnings as well as Fed policy, improving the outlook for equities in the second half of this year.  “While we reduced growth and EPS forecasts, we expect equities to be meaningfully higher at the year-end.”   However, data from Bank of America shows a big dispersion in how estimates need to fall for stocks to find a bottom.  In 2020, when the recession was the shortest on record, earnings estimates had fallen 3% when the market bottomed.  During the 2008 global financial crisis, they sank 36% before stocks hit a floor.

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