Q1 earnings: Will profit margins decline?

“The first three months of 2022 will be remembered as a period of extreme volatility for stocks. In addition to red-hot levels of inflation and supply-chain challenges carried over from 2021, Russia’s attack on Ukraine sent markets into a tailspin—and catapulted commodities prices higher. 

“And to combat these higher prices, the Federal Reserve initiated its first rate-hiking cycle in more than three years.

“Earnings take on more importance this time around ‘with valuation expansion potentially tough to come by due to rising interest rates and high inflation,’ says Jeff Buchbinder, equity strategist at independent broker-dealer LPL Financial.”

“The good news is that corporate sales are forecast to grow briskly in the first quarter, up from expectations earlier this year. 

“The bad news is that corporate profits are expected to grow about half as fast as sales. This margin compression doesn’t bode well for stock prices during earnings season, particularly since the market has run up in recent weeks.

“The earnings should show an economy that continues to steam along, despite rampant inflation and war in Ukraine. Analysts expect first-quarter sales for S&P 500 companies, in aggregate, to have grown 10.7% year-over-year, up from 9.7% expected growth at the start of the year. … With stocks getting more expensive, it’s less likely that they will post big gains after reporting earnings. The S&P 500’s aggregate forward earnings multiple is now about 19.3 times, up from a low of just under 18 times last month. Stock prices are now reflecting a large expected earnings stream in the future.”

“Over the last couple of seasons, beat rates have started to slow from the extreme levels that were the signature of post-COVID reports; a further deceleration this season remains a major risk given the market’s reliance on earnings in an environment full of negative catalysts for valuations.” 

• “Earnings Growth: For Q1 2022, the estimated earnings growth rate for the S&P 500 is 4.5%. If 4.5% is the actual growth rate for the quarter, it will mark the lowest earnings growth rate reported by the index since Q4 2020 (3.8%).
• “Earnings Revisions: On December 31, the estimated earnings growth rate for Q1 2022 was 5.7%. Seven sectors are expected to report lower earnings today (compared to December 31) due to downward revisions to EPS estimates.
• “Earnings Guidance: For Q1 2022, 67 S&P 500 companies have issued negative EPS guidance and 29 S&P 500 companies have issued positive EPS guidance.
• “Valuation: The forward 12-month P/E ratio for the S&P 500 is 19.2. This P/E ratio is above the 5-year average (18.6) and above the 10-year average (16.8).”

“Given that most S&P 500 companies report actual earnings above estimates, what is the likelihood the index will report actual growth in earnings of 4.5% for the quarter? Based on the average improvement in earnings growth during each earnings season due to companies reporting positive surprises, it is likely the index will report earnings growth of more than 10% for the first quarter, which would be the fifth consecutive quarter of (year-over-year) earnings growth above 10%.”