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Stocks could face the steepest correction since the 2022 bear market as earnings kick off, analysts say. Here's what investors should watch for.

Jul 12, 2024, 23:42 IST
Business Insider
Yichiro Chino/Getty Images
  • Second quarter earnings season could trigger the most painful stock correction since 2022, according to NDR.
  • The research firm warned of a shift from accelerating to decelerating growth in heading into 2025.
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Earnings season has officially kicked off this week, and it could bring the most painful correction for stock prices since the 2022 bear market.

That's according to Ned Davis Research, which offered a preview of what will matter most during the deluge of second-quarter earnings results over the next few weeks.

"The biggest risk could be a shift from accelerating to decelerating year/year growth toward the end of 2024 and into 2025," NDR strategist Ed Clissold said in a Thursday note.

That means that as strong as profit results might be this quarter, the future success of the stock market will largely hinge on company outlooks for the second half of the year.

Here's what investors should look out for during the second quarter earnings season, according to NDR.

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Second-half growth estimates

The typical pathway of Wall Street earnings growth estimates is for them to be overly optimistic at the start of the year, only to slowly be revised lower towards the end of the year.

Therefore, it's not a matter of whether analysts will cut their second-half earnings growth estimates but rather by how much they will cut.

"Last year, the growth rate was revised down 4.8% points, much less than the long-term average of 8.1%. It is one of the reasons why the S&P 500 surged 24.2%. So far in 2024, consensus has only been revised down 1.3% points, again one of the reasons for the 18.1% year-to-date gain," Clissold said.

Current analyst projections suggest S&P 500 earnings growth of 5.7% in the second quarter, 19.2% in the third quarter, and 19.6% in the fourth quarter.

And those rosy growth estimates could ultimately be setting the stock market up for failure, especially considering expectations for a slowdown in the US economy's growth rate during the second half of this year.

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Consensus earnings beats

Since the start of the now 18-month-old bull market, at least 78% of S&P 500 companies have exceeded consensus estimates, which is historically high.

That trend of breadth within company earnings beats will have to continue if the next inevitable stock market correction is to be pushed further down the road.

"Another high beat rate may be required to justify the rally," Clissold said. "Management teams have guided the Q2 year/year growth rate down to 5.7% from 7.0% at the end of May. The lowered bar makes a high beat rate more attainable."

Accelerating growth

"The concept that earnings growth is good for stocks seems intuitive. It is true, but with an important caveat. Investors look ahead, and they often view extremely strong year/year earnings growth as unsustainable," Clissold said.

With earnings growth surging in recent quarters, how sustainable that growth rate is remains a top question for investors, as decelerating growth is rarely rewarded with higher stock prices.

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"Earnings are in the sharp acceleration phase, and consensus estimates are calling for them to remain there through Q3. During Q2 earnings season, watch for whether expected year/year EPS acceleration comes to fruition and for guidance on how long it can continue," Clissold said.

The Magnificent 7 stocks

Since the start of this bull market, much of the S&P 500's earnings growth has been driven by a handful of mega-cap tech companies like Nvidia, Amazon, and Meta Platforms.

"Five of the seven grew by at least 20% versus Q1 2023, and three grew by at least 100%," Clissold said of the mega-cap tech's earnings growth.

As strong as that growth has been, it sets a high bar for these companies to continue to post fast enough growth that impresses investors.

"The hurdle is high. Consensus is calling for five members of the Mag 7 to post slower growth rates in Q2 than in Q1. Even strong beats may not be enough for Mag 7 growth rates to continue to accelerate," Clissold said.

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The other 493 stocks

For the bull market to continue, the other 493 S&P 500 stocks need to start pulling their weight in terms of earnings growth, and this earnings season could be the quarter it finally happens.

The 493 companies are expected to grow earnings by 1.1% in the second quarter, compared to first-quarter expectations of a 5.7% decline. These companies ultimately posted first-quarter earnings growth of 0.3%.

"Analysts are banking the Mag 7 to continue to drive earnings growth, but the rest of the market to participate more. The bar is noticeably lower outside the mega-cap favorites," Clissold said.

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