Why Earnings Season Couldn’t Save the Stock Market This Time

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Federal Reserve Chairman Jerome Powell at a news conference following a Federal Open Market Committee meeting in Washington, D.C.

Win McNamee/Getty Images

First-quarter results have been generally solid, but that has been little comfort for investors this earning season.

S&P 500 earnings per share are on track for 11% year-over-year growth, on a 13.5% increase in revenue, per data from Credit Suisse . Yet the index has dropped some 10% since the results started coming in early last month. The Nasdaq Composite has shed almost 20% in a month. What gives?

Simply put, investors are more focused on the macro than the micro these days.

It all comes back to the Federal Reserve and tightening monetary policy, with a handful of other wild cards that just introduce more uncertainty and volatility, including the war in Ukraine and all its tragic implications. Those have been a recipe for lower stock and bond prices, which move inversely to yields.

Overall, stocks’ price-to-earnings multiples have declined faster than profits have grown. The macro pressure has been especially strong on growth-oriented areas of the market—where the micro often hasn’t been particularly helpful either. The Vanguard S&P 500 Value exchange-traded fund (ticker: VOOV) has lost about 7% since the start of first-quarter earnings season, versus an 18% drop for the Vanguard S&P 500 Growth ETF (VOOG). 

For the past two years, the Fed held interest rates at practically zero and had been buying tens of billions of dollars of bonds and other securities each month, a process called quantitative easing. Now interest rates are going up and the central bank will begin allowing its balance sheet to shrink as its holdings reach maturity.

Bond and interest rate futures markets have moved in anticipation of more hikes. Current pricing implies another 2 percentage points of increases by the Fed through the end of this year, per data from CME Group , on top of the three-quarters of a percentage point of hikes at the past two meetings.

Higher benchmark interest rates and bond yields mean a higher cost of capital for businesses that rely on financing, whether it be issuing bonds, or bank borrowing, or venture capital. Companies that are projected to earn the bulk of their profits far out in the future are worth less today when those earnings are discounted back to the present using a higher discount rate.

Cash is effectively worth more today, favoring more mature, profit-generating businesses versus the startups and more early stage growth companies out there. That is why the shifting monetary policy environment has hit valuations of growth stocks the hardest in sectors like technology, software, consumer discretionary, or biotech.

Overall, S&P 500 value stocks trade for about 15 times their expected earnings over the coming 12 months. That is down from just over 17 times in early 2022. S&P 500 growth stocks, meanwhile, have seen their forward price-to-earnings ratio drop to below 21 times, from about 28 times, since the start of the year. That multiple has slid to 17 times, from about 21.5 times, for the S&P 500 as a whole.

That is the macro pressure on market multiples that has outweighed the first-quarter revenue and earnings growth, which has been strongest in the energy, materials, and industrials sectors of the S&P 500.

The micro hasn’t been as great for growth stocks this earnings season. S&P 500 value stocks have reported year-over-year earnings and revenue growth of 14.0% and 13.7%, respectively, versus 9.3% and 13.1% for growth, according to Credit Suisse.

Faster profit and sales growth from cheaper value stocks than highly-valued growth stocks? Not what investors have gotten used to.

At least some of the growth disappointment was predictable. The past two years of the pandemic were a goldilocks environment for many growth businesses—think e-commerce, streaming, and remote working. As Covid-19’s impact on everyday life recedes, some of those consumer habits will reverse, or at least not continue to accelerate endlessly. 

That hangover has shown up in many growth companies’ first-quarter earnings: Netflix ( NFLX ) saw a decline in subscribers, Teladoc Health (TDOC) wrote down the value of its business, and online retailers like eBay (EBAY) and Etsy (ETSY) have taken it on the chin for their gloomy 2022 financial forecasts despite solid first-quarter numbers, to name a few.

Pair the Fed tightening the noose with those high-profile disappointments from growth stocks, and you have a declining market despite solid earnings headlines.

Write to Nicholas Jasinski at nicholas.jasinski@barrons.com