The Big Picture
We know from the September Employment Situation Report that the labor market is holding up fine. That should bode well for the economy, and what bodes well for the economy should bode well for earnings growth.
We're using a conditional tense because we won't know for sure if earnings live up to the market's expectations until... well until we know. Fortunately, we are on the cusp of knowing.
The third quarter earnings reporting period is upon us.
A Cut Too Deep
According to FactSet, the blended third-quarter earnings growth rate (accounts for reported results and estimates for companies that have yet to report) stands at 3.9%. The estimated earnings growth rate stood at 7.8% on June 30, so clearly analysts have reined in their expectations.
A manufacturing sector in contraction, sliding energy prices, some signs of weakening in the labor market, a struggling Chinese economy, fading pricing power, and various reports highlighting a pullback in discretionary spending by lower and middle-income consumers were among the factors contributing to the cut in the earnings growth estimate.
With lots of history to draw on, that cut will likely prove to be too deep. Earnings growth typically exceeds the estimate going into the start of the reporting period by at least two percentage points.
With the earnings growth estimate being where it is today, it's a stretch to suggest the market has high expectations for this reporting period. It doesn't. The high expectations are rooted in the quarters to come, which is why the guidance coming out of the third quarter earnings reporting period will be key.
FactSet estimates show fourth-quarter earnings are expected to be up 14.2% followed by 14.5% growth and 13.6% growth in the first and second quarters of 2025, respectively. For calendar 2025, S&P 500 earnings growth is projected to be 15.1%.
Making a Contribution
Not surprisingly, the information technology sector is where the bulk of third-quarter growth is expected to be concentrated. The blended growth rate for the sector is 15.0% and it is expected to contribute 2.99 percentage points to growth.
The other big growth contributors are the health care (1.28 percentage points) and communication services (1.00 percentage point) sectors. Sectors that are expected to detract from growth are the energy (-1.61 percentage points), financial (-0.15 percentage points), and materials (-0.09 percentage points) sectors.
There will be a better line on the financial sector's contribution soon enough. JPMorgan Chase (JPM), Wells Fargo (WFC), BNY Mellon (BK), and BlackRock (BLK) will step to the reporting plate on October 11, and they will be followed by a large portion of their sector brethren the following week.
The reports from the banks will be looked at carefully, with a special emphasis on their characterization of credit quality. With the market's high earnings expectations for coming quarters, it will want to hear that credit quality is holding up and not driving large provisions for loan losses.
The Amazing NVIDIA
This reporting period will be no different from other reporting periods in that the so-called "Magnificent 7" will be the fulcrum for determining if this reporting period amazes or disappoints the market.
The latter has been full of amazement for some time now and for good reason. None of the Magnificent 7 has been more amazing recently than NVIDIA. Expectations for this company are sky-high.
According to FactSet, if NVIDIA is excluded, the estimated year-over-year earnings growth rate for the information technology sector would be 8.2%. Below one will see the comparable estimated year-over-year third-quarter earnings growth rates for the Magnificent 7 based on FactSet estimates:
- Apple (AAPL): 7.5%
- Microsoft (MSFT): 3.7%
- NVIDIA (NVDA): 85.0%
- Alphabet (GOOG): 18.1%
- Amazon.com (AMZN): 21.3%
- Meta Platforms (META): 18.2%
- Tesla (TSLA): -10.6%
These stocks command most of the attention, but Berkshire Hathaway (BRK.B) and Broadcom (AVGO) can't be overlooked as "mega caps." Their market capitalization exceeds Tesla's, and Eli Lilly (LLY) is another heavyweight with a market cap that rivals Tesla's. These three stocks and the Magnificent 7 account for 38% of the S&P 500's total market capitalization.
Netflix (NFLX), meanwhile, isn't a mega-cap stock. Its market capitalization is "just" $308 billion, yet it still has ample pull as a driver of market sentiment.
What It All Means
Earnings and earnings expectations are what drive the stock market. There are high hopes for what is to come. That point is borne out in a forward 12-month P/E multiple of 21.5x for the market-cap weighted S&P 500 which is 19% above the 10-yr average of 18.0x.
The forward 12-month P/E multiple for the equal-weighted S&P 500 is 17.1x. That looks better in absolute terms, but it is also a slight premium to the 10-yr average of 16.4x; moreover, there isn't a distinct value advantage over the market-cap weighted S&P 500 when taking into account that both trade with a PEG rate (price-to-earnings growth) of 1.5. In effect, one is paying a comparable premium for the projected earnings growth.
The good earnings news priced into these indices needs to keep coming or they will be at increased risk of multiple compression knowing stock prices tend to go down faster than they go up, especially when an earnings disappointment occurs.
Like any earnings reporting season, there will be surprises during the third quarter reporting period. How the market responds will hinge on what companies are doing the surprising and whether they are doing it in a positive or negative manner.
All eyes will be on the Magnificent 7 in that regard, yet the other 493 companies in the S&P 500 will have some say in things, and what is said needs to meet the market's high earnings expectations.
