Q2 2022 earnings preview: are we worrying too much?

The recent decline in stocks has reminded the market that sentiment remains shaky. Softer macro-economic data has renewed fears that Fed tightening will trigger a recession, this combined with continued scrutiny that current Q2 earnings estimates are too high is causing a deteriorating picture for risky assets. This is a difficult backdrop as we lead up to the second quarter earnings season, that will start in a couple of weeks.

S&P 500: Analyst estimates remain positive in the long term

Ahead of earnings season, there are two surprising factors to consider. Firstly, the bottom-up price target for the S&P 500 declined by 7% on the 23rd of June, according to FactSet. This is the first time that the bottom-up price target for the US index has dipped below 5,000 since August 2021. Interestingly, the bottom-up price target on 23rd June, was still 31% above the actual closing price of 3,795. The bottom-up price target is calculated by aggregating the median price estimates of the major industry analysts, for all companies in the S&P 500. This suggests that analysts are still more bullish than the overall market even if they have recently revised down their price targets. Considering analysts are thought to have a deeper understanding and greater knowledge of financial markets than the average person, it suggests that analysts are more optimistic about stocks, and this could be considered a bullish signal. Interestingly, industry analysts still believe that the S&P 500 will increase by 30% in the next 12 months, this is unusual since industry analysts tend to under-estimate the closing price of the index in 12 months’ time.

Buy ratings remain resilient

Added to this, industry analysts also have an unusually high number of buy ratings on S&P 500 companies, even with their lowered price target. Currently 57.7% of all ratings on the S&P 500 are buy ratings, this compares with the 5-year average of 53%, according to FactSet. Thus, do analysts know more than we do when it comes to the outlook for US stocks?

To answer this question, it is worth looking at the sectors that analysts are favouring, as they are not universally bullish. The companies with the largest number of buy ratings include Alphabet (Google), Microsoft, S&P Global – the ratings agency, IQVIA Holdings and T Mobile US. In contrast, the companies with the highest number of sell ratings include Snap-On – the power tool manufacturer, Robert Half International, Lumen Technologies and Vornado Realty Trust. These companies, including those linked to real estate and construction, are not currently favoured by analysts, which is why traders may want to differentiate before they buy stocks at this stage of the cycle.

The bull case for stocks: buy energy and ditch consumer discretionary

One reason to explain analysts’ optimistic outlooks in terms of ratings is that analysts have continued to increase earnings estimates for S&P 500 companies in aggregate for full year 2022 and 2023. In the last two months, analysts have decreased their earnings estimates for S&P 500 companies for Q2. The bottom-up decline in earnings estimates was 1.3%, according to FactSet However, before you push the sell button, it is worth remembering that it is typical that EPS estimates decline in the first two months of a quarter. During the past 5 years, the average decline in EPS estimates has been 1.9%, in the past 10 years it has been 2.7%. Thus, analysts have revised down their EPS estimates by a smaller amount than usual for the last 5 and 10 years, suggesting that there was too much pessimism in the market.

On the sector level, 7 out of 11 sectors on the S&P 500 have seen a decrease in EPS estimates, led by consumer discretionary, down more than 15%, and communication services, down more than 7%. In contrast, the energy, materials, and real estate sectors have all had their EPS estimates revised higher ahead of Q2 earnings season. The energy sector has seen its EPS estimates revised up by a whopping 29%, on the back of sustained upward pressure on the oil price.

Earnings estimates remain positive for the long term

Analysts may have revised down their estimates for Q2 earnings, however they have revised up their earnings for 2022 as a whole and they are increasing their EPS estimates for Q3 and Q4 by small margins. EPS estimates for 2022 have been revised higher for energy, materials, industrials, and real estate, while consumer discretionary, communications and health care have seen their EPS estimates revised lower for full year 2022. This optimism has also spread to 2023, where the EPS estimate for the full year has been revised up by 0.6% so far.

With stock prices falling and earnings estimates rising, the 12-month forward P/E ratio for the S&P 500 has declined to 17.4 from 19.4. Thus, stocks are getting cheaper, at the same time as analysts are more bullish on the outlook for stocks than the general market, which some may see as a bullish sign for stocks in the long term. However, we have pointed out that investors are favouring certain sectors over others, thus, if earnings season is a market-mover in the coming weeks, we could see the energy sector continue to outperform the consumer discretionary sector for some time yet. This is not a great time to trade the overall index, instead pick your sectors wisely!