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Can Stocks Rebound?

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The stock market’s loss of altitude in recent days has pushed most major indexes into ‘correction’ territory, raising hopes among many that the worst may be behind us. But there are others that cite various reasons to stay bearish, keeping alive questions about the market's next move.

I am adding to that debate in this piece by pointing out a source of support for the market that will help not only stabilize, but actually rebound in the days ahead.

Stocks need power to push higher, just as humans and machines do. For stocks, this 'power' comes from a variety of sources, but interest rates and corporate profits are the biggest drivers.

Interest rates have been market-friendly for the last many years, with forceful Fed action during the pandemic cementing that role. But we have reached an inflection point with the Fed’s interest rate policy, as worries about runaway inflation have prompted the central bank to start normalizing monetary policy by removing the accommodative measures it put in place during the pandemic.

The current market pullback is a reflection of market participants’ uncertainty about the speed and magnitude with which the Fed will change interest rate policy in the days ahead.

A big part of the ongoing inflationary pressures in the economy is because of the pandemic’s impact on global and local supply chains. The other part is a result of the stronger-than-expected post-pandemic demand that likely got exacerbated by stimulative fiscal measures.

The Fed fully understands that no policy change on its part will have a bearing on stretched global supply chains. Its goal instead will be to take the edge off excess demand by removing the extraordinary stimulus measures like ending the QE program and instituting some interest rate hikes. What this means is a modest rise in interest rates in an otherwise stable interest rate and economic backdrop.

I am not making light of this Fed policy change. This is a big deal, particularly for parts of the market that require a high degree of risk tolerance. Such investments, like SPACs and stocks of small, high-growth companies with minimal current profitability, have been hit hard in the recent downturn.

But the stock market is much more than just speculative operators or hyper-growth small companies whose profits lie out in future years. This brings us to the second force we mentioned earlier that powers stocks higher-corporate earnings.

The earnings picture took a severe beating as a result of the pandemic, but it enjoyed an impressive rebound, with aggregate totals in each of the first three quarters of 2021 successively reaching new all-time records. This was despite continued pandemic-related issues in the broader leisure, hospitality and travel spaces.

Early indicators suggest that this performance momentum will remain in place in the ongoing 2021 Q4 earnings season, with the reporting cycle ramping up significantly in the coming days.

We strongly believe that investors will find it difficult to justify continued market weakness in the face of very strong earnings releases in the days ahead. The market set up for this earnings season couldn’t have been better.

Earnings growth remains very strong, with the ongoing 2021 Q4 earnings season on track to show growth in excess +22%, with the positive growth trend continuing in the current and coming quarters, albeit at a lower rate.

This growth pace represents a deceleration from the first half’s breakneck speed, but it is still very strong by historical standards. This would come after the COVID-19-driven declines of 2020 when earnings dropped by -13%.

Continued . . .

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Many skeptics have been discounting this favorable turn in the earnings growth picture, citing the expected deceleration in earnings growth in 2022 after 2021’s breakneck pace. This narrative argues that given the already stretched level of aggregate valuation metrics, we would need the incremental developments on the earnings front to remain positive to help support the market.

These are reasonable points. But what we need to keep in mind with respect to the market is that we don’t need continuation of the outsized growth for the first half of 2021 to push stocks higher. What we do need, however, is an environment of improving earnings outlook, with estimates steadily going up. And that’s exactly what we have at present.

We make the following two points in support of this view:

First: The revisions trend remained positive through the first three quarters of 2021, but modestly turned negative in the last three months of the year.

What this means is that estimates for 2021 Q4 went down modestly after the period got underway at the start of October. But this has started to change already, with estimates for 2022 Q1 going up in recent days.

Earnings for S&P 500 companies are currently expected to increase by +4.6% in 2022 Q1, which is up from +3.7% growth expected at the start of January 2022.

We are seeing a similar favorable revisions trend for estimates for 2022 Q2 as well.

Second: The favorable revisions trend is broad-based and not concentrated in one area, though the Energy sector has been a big beneficiary of the recent momentum in oil prices.

Looking at full-year 2022 earnings estimates, estimates have gone up by more than +15% in the past 12 months and by more than +5% in the last 6 months. In fact, full-year 2022 estimates have gone up by +1.7% since the start of October 2021, with the net revisions trend staying positive even on an ex-Energy basis.

The next point will make the case for the revisions trend to accelerate meaningfully in the coming months as the Omicron-driven infection surge recedes, helping revive activity levels that had been dampened by the highly infectious variant.

The fact is that there is no fundamental reason for stocks to lose ground as long as interest rates remain stable and earnings estimates maintain their current uptrend.

The bottom line is that there is significant upside to current consensus earnings estimates. And an environment of rising earnings estimates and stable interest rates should keep stocks on an upward trajectory. 

Putting It All Together 

In the ongoing Q4 earnings season, companies are not only coming out with impressive results, but also providing positive guidance for the current period and beyond even as they explain the cost pressures and supply-chain challenges.

Current estimates for this year and next represent strong earnings growth, but we remain very confident that the growth pace should continue to go up as a result of favorable estimate revisions. In fact, there is a strong likelihood that the outlook for economic and earnings growth will turn out to be a lot stronger than currently reflected in consensus estimates.

The stock market’s positive momentum is grounded in the fundamental reality of an improving earnings outlook and a very favorable interest rate environment. We see no reasons for this trend to stall or reverse as long as these fundamental drivers remain in place.

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Thanks and good trading,

Sheraz Mian

Sheraz Mian serves as the Director of Research and manages the entire research department. He also manages the Zacks Focus List and Zacks Top 10 Stocks portfolios. He invites you to access Zacks Investor Collection.

¹ The results listed above are not (or may not be) representative of the performance of all selections made by Zacks Investment Research's newsletter editors and may represent the partial close of a position.