Why Earnings Season Could Be Setting Stocks Up for a Bear Market Trap

Stock performance has been lackluster after earnings reports, which is disappointing for a market that was expecting strong results.

Investors are not expecting great earnings news. Expectations have already dropped leading into reporting season, with fourth-quarter earnings-per-share estimates for the index falling about 7% from September through the end of the year, according to Credit Suisse. The main driver of this is that economic demand is softening as the Federal Reserve lifts interest rates, a move designed to lower the rate of inflation.Concerns remain as inflation falls for the 6th straight month. The consumer-price index fell 0.1% over the month in December, compared with a 0.1% climb in November. However, the cost of services is still a problem. This inflation is still pressuring profit margins as companies lose the power to raise prices even as wages rise.

The consumer-price index fell 0.1% over the month in December, compared with a 0.1% climb in November. However, the cost of services remains a problem.

In general, "fear mongering" lowered the earnings bar, according to Chris Harvey, chief U.S. equity strategist at Wells Fargo.

According to Refinitiv, 95 S&P 500 companies have reported earnings so far, and 67% of them have topped analyst expectations. However, the aggregate earnings per share for all companies is only 1.7% higher than expected. These stats are not particularly impressive.

Companies have, on average, reported earnings 4.1% above those expectations since 1994. This means that, on average, two-thirds of companies beat earnings forecasts.

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Despite this, the resulting earnings beats have been good enough. According to Evercore ISI data, the average stock has gained 0.5% after reporting, while shares of companies that surpassed both sales and earnings-per-share estimates have gained 0.8%. This is below the five-year average of a 1% gain, but double misses haven’t been punished as much as they usually are—they’ve dropped 1.6% on average, below the 2.9% average over the past five years.

The stock market's recent rally shows why stocks are a better investment than cash. With the market up since the beginning of the year, valuations are higher than they were just a few months ago. This is despite the fact that the economy is facing some uncertainty, with the Federal Reserve remaining in rate-hiking mode and the market unsure of whether we are headed for a recession or a soft landing. Companies' guidance is also difficult to interpret in this environment. However, the stock market's strong performance so far this year indicates that stocks are still a better investment than cash.

At the beginning of this year, it was reasonable to believe that cash would be a better investment than stocks. However, stocks have already begun to challenge that assertion.

Martin Roberge, portfolio strategist and quantitative analyst at Canaccord Genuity, believes that the market is heading for more declines. He notes that the market’s recent rebound after a down year in 2022 is reminiscent of a surge seen two decades ago, just before more declines took hold. Following a terrible 2000, the S&P 500 rose 4% during January 2001 earnings season, as results convinced some investors that the worst of the tech wreck was over. However, analysts kept cutting their earnings forecasts, setting the market up for a larger decline over the rest of that year.

According to Roberge, switching to a more bullish mode without earnings visibility carries the risk of repeating the bear market trap of 2001.

We can only hope that history does not repeat itself.