This Is What To Expect From The Q3 Earnings Cycle

Investors Should Brace For The Worst

The analysts are expecting good things from the S&P 500 (NYSEARCA: SPY) during the Q3 earnings season, as are we, but that's not what investors should be worried about. While earnings growth is expected to be robust once again, the dark cloud of inflation and supply chain issues is cutting into the outlook. The risk for investors is not so much that earnings growth will fall short of the consensus estimate but that growth will fail to inspire and the outlook for Q4 earnings will deteriorate. In a market where great results are already baked into the cake, less than expected results and a deteriorating outlook for future earnings is a recipe for a market correction.

The Analyst Are Cooling Off

One of the more noteworthy trends of the post-pandemic environment is that the analysts have been cautious in their estimates and have consistently been upgrading their outlook on a quarter-to-quarter basis as each earnings cycle unfolded That same trend was evident in the Q3 consensus for earnings growth up until a few weeks ago. The consensus estimate for Q3 earnings growth among S&P 500 companies is 27.6% which is a great figure but flat over the past two months and down 50 basis points from the high of 28.10%. This fact is a red flag that should not be ignored because it reflects deteriorating sentiment among the analysts.

The downtrend in earnings estimates has been driven by reports from companies like Lennar (NYSE: LEN), Federal Express (NYSE: FDX), and Nike (NYSE: NKE). All three businesses are well supported by secular trends but also impaired by the combined impacts of inflation and supply chain woes. In all three cases, inflationary issues are cutting into the bottom line and causing a downshift in earnings expectations while in specific cases like Nike and Lennar, supply chain issues are also cutting into the top line. if this trend continues, the S&P 500 may hit its targets for the Q 3 season but it will not exceed them in a meaningful way and the outlook for the fourth quarter will deteriorate.

Looking to the fourth quarter estimates, the trend of consensus for earnings growth has flattened over the past two months and could easily begin to decline over the next couple of weeks. The peak of the season will begin the week of October 11th with reports from the big banks. The financial sector is expected to produce moderate double-digit growth in the range of 17.6% and that estimate has been rising. Of the 13 S&P 500 sectors, the consensus for earnings Is trending higher in only 6.

This Is Where To Look For Strength During The Q3 Season

The Materials sector is expected to post the largest YoY growth at nearly 100% and has also seen the greatest rate of revision since the start of the quarter. The Materials sector is driven by robust demand across Industries and verticals and throughout the system so should be able to easily outpaced the consensus. The risk for the materials sector is transportation and logistics including both availability and cost so we are a little cautious on the sector. The risk for the market is that materials company's like H.B. Fuller (NYSE: FUL) are going to raise their prices again in the 4th quarter.

The consumer sectors, both Discretionary and Staples, have the lowest expectations for earnings growth and both have seen their consensus figures trend lower over the quarter. We think this is setting them up to outperform. The consumer remains strong, there is no reason to think otherwise, so we are expecting the Consumer Staples sector and the Consumer Discretionary sector to smartly outperform their consensus expectation. The caveat is that those with a more U.S.-centric business will do better than those that don't. Nike is a prime example.

The Technical Outlook: The Trend Is Up But Be Wary

The S&P 500 is recovering from a 5% correction that took the index down to the 4300 level. The rebound appears to be strong and looks like it will easily retest the recently set all-time high but we are wary. With the S&P 500 set up to disappoint the market the way they are, we see the risk of a Double Top forming at the 4550 level. Until the market is able to surpass that level, we are cautious and see a high probability for another market correction. The question now is if the SP 500 will break the trend and move sideways within a new range or fall below 4550 and move down deeper into correction territory.