Profits Really Are King

By Partner & Portfolio Manager, Dr. JoAnne Feeney

The last several quarters have shown that shifts in macroeconomic forecasts, such as economic growth, longer term interest rates and Federal Reserve policy, can toss stocks about like a boat in rough seas. Despite those cross currents and the occasional rogue wave, investors nonetheless must successfully navigate towards a port that lies somewhere over the horizon. One navigational aid that investors consistently call upon is the outlook for future firm profits. And while higher interest rates tend to create headwinds for equities, an upgrade in estimates for corporate earnings provides tailwinds. This year has offered plenty of both, but a closer look at the market over the long term suggests that investors are attuned to harnessing those tailwinds. Even as the Fed continues to fight the inflation battle, the outlook for earnings may instead hold the key to where the market goes next.

Lately, the improvement in the economic and earnings outlooks has been mostly offsetting the headwind of higher rates. While the 10-Year Treasury yield rose from 3.9% to over 4.2% over the last six months, the S&P 500 climbed 13.8%:  

Some of the rally has been driven by a favorable shift in recession risks. Inflation has come down and labor markets may be starting to loosen. Investors realize that while the Fed may very well increase interest rates a bit further (and keep them there longer than most expected a year ago), the tightening in monetary conditions does not seem to be triggering a recession. At least, not yet and not for the foreseeable future.

More importantly, and related, investors are seeing better prospects for earnings ahead. Earnings projections for the largest 500 or so U.S. companies have risen off their lows of early this year. Indeed, the earnings outlook has increased notably just in the last month or so and projections for this quarter’s results point to year-over-year earnings growth for the first time since the third quarter of 2022.

The appreciation in equities reflect better sales and profit results that came from some of the largest companies in the U.S. throughout the mid-year reporting cycle. Investors correctly updated their views of profit potential and pushed equity valuations higher. Recall that the buzz last winter and spring centered on the opportunities ahead in the deployment of generative artificial intelligence models, but we are also seeing greater profit resilience in many consumer, industrial, and health care companies. The S&P 500 has climbed 23% since its October 2022 trough, and the appreciation has spread beyond the big technology and consumer companies that kicked off that rally. Note also that the market tends to rise in advance of an increase in earnings estimates. Investors understand that they own stocks for the profits a company can deliver in the future, not for those it generated in the past. Improving forecasts have enabled equities to continue climbing.

Thursday’s report of lower unemployment claims than expected may cause investors to worry that the Fed will have to raise rates further, but if earnings outlooks continue to improve, stocks could power through another uptick in rates. The long-term investor knows, also, that successfully navigating to port requires tacking into the headwinds and taking advantage of the tailwinds. Constructing portfolios to include companies that pay solid dividends and do well when macro risks or interest rates rise, for example, is one way ACM tries to tack into the wind to make progress towards your investing goals.

“The pessimist complains about the wind; the optimist expects it to change; the realist adjusts the sails.”

― William Arthur Ward, American Writer

The foregoing content reflects the opinions of Advisors Capital Management, LLC and is subject to change at any time without notice. Content provided herein is for informational purposes only and should not be used or construed as investment advice or a recommendation regarding the purchase or sale of any security. There is no guarantee that the statements, opinions or forecasts provided herein will prove to be correct. Past performance may not be indicative of future results. Indices are not available for direct investment. Any investor who attempts to mimic the performance of an index would incur fees and expenses which would reduce returns. Securities investing involves risk, including the potential for loss of principal. There is no assurance that any investment plan or strategy will be successful.