Earnings season kicks off this week, the next test for a stock market rattled by the prospect of quicker interest-rate increases by the Federal Reserve.
The market fell Wednesday on news that the Fed might lift short-term interest rates as soon as March, and it extended its decline throughout the week. The S&P 500, which soared 27% in 2021, fell 1.9% in the first week of the new year. The tech-heavy Nasdaq Composite recorded its worst week since February. The yield on the 10-year U.S. Treasury note rose to 1.769%, its highest since January 2020.
Low interest rates make investors more willing to pay rich valuations for stocks, and equity valuations shot higher in 2020 after the Fed slashed its benchmark rate to near zero. In 2021, price-to-earnings multiples remained higher than the long-term norm but started to edge lower. Now that rising rates are in play, potentially causing multiples to contract further, investors are rethinking their game plans. That means earnings growth will be critical for the market to continue its upward climb.
“Given where multiples are today, that’s what you need is consistent growth to keep the rally going,” said Mike Stritch, chief investment officer at BMO Wealth Management. “Even if interest rates weren’t going up, I think we were kind of at the high end of what people would be willing to pay for a dollar of earnings.”
Investors will get their first big look at the state of corporate profits when many financial companies report later this week. JPMorgan Chase & Co., Citigroup Inc. and Wells Fargo & Co. report on Friday and can serve as bellwethers for the health of the broader economy. Delta Air Lines Inc., which reports Thursday, could help investors parse how airlines are handling a Covid-19 surge.
Analysts estimate that profits from companies in the S&P 500 rose 22% in the fourth quarter from a year earlier, according to FactSet. That would be a higher-than-average growth rate but much lower than in the past few quarters, when results were being compared against the knocked-down profits from early in the pandemic. In the second quarter of 2021, for example, S&P 500 earnings grew 91%.
The return to earth is expected to continue in the new year. Earnings from S&P 500 companies are expected to rise 9.4% in the year 2022, a slower pace than the 45% profit growth estimated for the year 2021. In 2019, the last full year before Covid-19 began affecting the U.S. economy, profits edged down about 0.1% for the year.
Investors examining corporate results in the coming weeks will look not just at the bottom line but how companies got there. While managers are facing rising costs for everything from raw materials to labor to shipping, many have succeeded in passing expenses along by raising their own prices.
The net profit margin for the S&P 500 hit 13.1% in the second quarter of 2021, the highest level in data going back to 2008, according to FactSet. It slipped to 12.9% in the third quarter and is expected to fall to 11.9% in the fourth.
How executives talk about the coming months might have the biggest effect on markets. Investors will want to know how the spread of the Omicron variant could continue to affect business. And they will be eager to hear how companies plan to manage wage increases and higher transportation costs, among other expenses.
“I do think from a guidance standpoint it could be pretty tricky for companies here in 2022,” said Jimmy Chang, chief investment officer at Rockefeller Global Family Office. “All these input costs have risen quite a bit compared to this time last year.”
The stakes are especially high for growth stocks, which trade at hefty multiples because they promise expanding future profits. Rising yields can hurt pricey stocks in particular because higher yields pressure the value of companies’ future cash flows. Higher yields also give investors more options as to where to park their money for a profit, making them less willing to take a risk on stocks.
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Many growth stocks are found in the technology sector, which is expected to report lower earnings growth in the fourth quarter than the stock index as a whole. The tech sector traded last week at 27.1 times its projected earnings over the next 12 months, higher than the S&P 500’s multiple of 20.7 times. The energy group, by comparison, traded at 11.9 times its projected earnings and the financials group traded at 15.2 times.
During last week’s trading, the tech sector fell 4.7%, while energy rose 11% and financials added 5.4%.
“Especially given the valuations of some of the technology, there isn’t a lot of room for error here,” said Linda Bakhshian, a senior portfolio manager at Federated Hermes who focuses on value-style stocks. “So we really do need those margins to come through and their commentary to support continued performance into 2022.”
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