The Biggest Risk in the US Stock Market: Earnings per Share May Have Peaked

Wall Street's expectations for corporate earnings in the US stock market may decline, pushing the market in the same direction.

Data shows that although analysts are optimistic about profits, market sentiment has started to shift.

Market overly optimistic about US stock earnings growth

Firstly, according to data from FactSet, over the past 6 months, the overall earnings per share forecast for S&P 500 index constituents for 2023 has increased by about 1.4%, sales growth expectations are slightly below 1%, and profit margin expectations have slightly increased due to the easing pressure on corporate profits from employee wage increases.

Secondly, according to data from the Royal Bank of Canada (RBC), approximately 58% of the earnings per share forecasts for S&P 500 index constituents for 2023 and 2024 have been revised upwards. However, earlier this year, this proportion was less than 40%.

Historically, this figure has reached about 80%, but these peaks usually occur after an economic recession, when a new economic expansion begins. For example, in 2003, 2019, and 2021.

However, when the economy has been growing for several years and concerns about a possible slowdown in the economy are increasing, this proportion often does not exceed 60% or 70%. It frequently falls below the current level, indicating that downward revisions may account for a larger proportion of the adjustments.

Earnings have peaked

Early signs have shown that earnings expectations have peaked. Although earnings per share expectations have increased over the past six months, they have declined in the past few weeks.

Data from DataTrek Research shows that earnings per share expectations for S&P 500 index constituents for the third quarter decreased by about 0.4% last week, to $57.85.

Nicholas Colas, the founder of DataTrek, wrote in the latest research report: "As analysts finalize their expectations for the third quarter, further downward revisions are expected in the coming week."

The economic weakness caused by higher interest rates could lead to more rate cuts. The Federal Reserve may be nearing the end of its rate hikes as inflation rates have been declining, but it will maintain high rates for some time.

The impact of rate hikes on the economy often lags, so it may cause greater damage to the economy and corporate sales.

US stocks need to be cautious

All of this is particularly important because US stocks are already expensive.

The price-to-earnings ratio for S&P 500 index constituents based on expected earnings per share for the next 12 months is about 18 times, slightly higher than the ratio at the beginning of this year, which was slightly above 16 times.

While bond yields are rising, this ratio is also increasing, indicating that the US stock market is currently optimistic about earnings per share growth.

However, if analysts lower their earnings per share expectations, US stocks will have significant downside potential.