5 Reasons Earnings May Beat Expectations — and Continue Fueling the Rally

It's widely expected that earnings per share (EPS) for S&P 500 companies will decline by 7.3% year over year (YoY) on falling revenues close to 1%. But despite some high-profile misses, 68% of the approximately 20% of companies that have reported so far this quarter are beating their estimates by an average of 7%.¹

That puts EPS for the S&P 500 on pace for a much lower than anticipated decline.

In fact, the expected YoY decline of just over 7% will likely be closer to 2% — assuming a typical beat rate of a little more than 5% for the rest of earnings season.²

Looking beneath the surface reveals more pockets of strength. Financials are expected to have YoY EPS growth of 8.6%. And Technology companies, broadly defined, are expected to grow earnings more than 6% YoY.³

Still, investors remain cautious — skeptical of a rally with narrow breadth that’s largely been driven by multiple expansion. But earnings will likely continue to beat expectations and fuel the rally — as they have for the past two quarters — for these five reasons:

1. Earnings for Energy and Materials are forecasted to contract YoY by 45% and 28%. If you exclude these two sectors that make up just 6.5% of the S&P 500, the index would be expected to grow earnings by about 1.5%. ⁴
2. Earnings weakness is concentrated in the largest cap names. On a median basis, EPS for S&P 500 companies are expected to grow YoY by a little more than 1%.⁵ 
3. Current estimates for declining revenues don't include beats. Companies are beating, and they will continue to beat. And, based on history, they’re likely to beat in the 4 to 5% range in aggregate on average, possibly more.⁶ 
4. After five quarters of weak EPS growth, Technology stocks are expected to outpace the market. This forecast applies for this quarter and the rest of the year. And it could be a major tailwind given the size of Technology’s market cap.
5. Earnings growth is expected in the third and fourth quarters. If the forecasts are correct, Q2’s earnings season will mark the bottom of this cycle — and from here on out, earnings could grow.

Expanding Operating Margins to Further Fuel Rally

It’s important to evaluate operating margins alongside earnings. Margins peaked about a year and a half ago. After persistently declining, margins have recently stabilized with the record high spread between the Consumer Price Index (CPI) and Producer Price Index (PPI).

This large gap supports margins. Why? Consumers are still capable of paying high prices, given the strength of the labor market. But the PPI for finished goods on a YoY basis is now negative.⁷ That means input costs are falling for businesses, something that helps earnings and bodes well for margins.

For example, when Pepsi beat this quarter’s earnings expectations, it wasn’t on higher volumes, but on increased prices. Bigger picture, many companies are not selling more products, they are boosting revenue with higher prices. And that keeps their margins elevated.

That’s important because with margins expanding again, it's very difficult for the economy to enter a recession.