As Goes the Economic Data, So Goes Profits and Stock Prices

The S&P 500 just notched a new all-time high this week, closing above 5,790 for the first time on Wednesday.

Meanwhile, the U.S. economy looks just fine. In fact, upside surprises in the economic data just turned positive – for the first time in five months.

And to top it all off, interest rates are coming down. The Federal Reserve has already lowered short-term rates by 0.5%, with a promise of more easing by year’s end – and even lower rates forecasted to come in 2025. You may be hearing the old Wall Street maxim again: “Don’t fight the Fed.”

So, what could go wrong with this bullish scenario? Hopefully, nothing.

But hope isn’t a good investment strategy. We should be ready for volatility between now and Election Day, and the biggest potential catalyst for stocks between now and November is the upcoming third-quarter earnings season, which kicks off tomorrow.

Over the next three weeks, more than 300 companies in the S&P 500 Index will report their most recent quarterly results. And Wall Street is looking forward to good news: Overall, S&P 500 companies are expected to report a respectable year-over-year profit growth of 5% for the last quarter.

That’s lower than the blended earnings growth rate of 10.5% for the first two quarters of this year. But companies have been exceeding Wall Street forecasts recently, coming in about 3% above estimates on average. So, the S&P’s actual profit growth could be closer to 8%.

Analysts have been busy reducing profit forecasts in recent months. But as we enter earnings season, the sectors expected to report the strongest year-over-year earnings growth include the usual suspects – Technology, expected to grow 15.1% and Communications Services, with a 12.3% growth forecast – followed unexpectedly by the Health Care sector, expected to grow by a solid 11.2%:

Of the 11 component sectors of the S&P 500, Health Care has the unique distinction of being the one and only sector that has experienced upward analyst estimate revisions over the past year. Every other sector has seen profit estimates cut, according to data from the Institutional Brokers’ Estimate System (I/B/E/S).

However, there’s one red flag that keeps bothering me about the S&P’s earnings growth: Technology and Communications Services continue to do most of the heavy lifting for the S&P 500 Index as a whole.

The faster-than-average profit growth we’ve seen from the S&P 500 recently continues to be driven largely by the beloved mega-cap technology and communications stocks we know as the “Magnificent 7.”

Meanwhile, earnings estimates for companies in the S&P 600 Small-Cap and S&P 400 Mid-Cap indexes have stalled out:

Small-cap profit forecasts are actually down about 10% from a year ago, while mid-cap profit forecasts are roughly flat over the past year.

The good news for the capitalization-weighted S&P 500, which accounts for a bigger share of U.S. corporate profits, is that nearly 75% of S&P 500 companies have experienced upward earnings estimate revisions over the past year.

That’s the highest level since the 2020-2021 post-pandemic earnings boom.

And as I mentioned earlier, another big plus for stocks is that U.S. economic data have turned positive again after a long drought:

As shown above, the Citigroup U.S. Economic Surprise Index just moved positive – after spending over 100 days below zero.

This index measures the number of economic data reports that exceed or fall short of analyst expectations. So, a reading above zero indicates that more reports have been positive than negative!

And this index has a high positive correlation with S&P 500 returns.

In fact, over the past 20 years, when the Citi Economic Surprise Index moved into positive territory after spending 80 or more days below zero, the S&P 500 Index went on to rise 92% of the time over the following 12 months, with median gains of 14.3%.

It’s a great setup for the market – as long as you don’t forget about the seasonal volatility.

Mike Burnick’s Bottom Line: As economic data goes, so typically goes future corporate profits. So, keep a watchful eye on third-quarter earnings results, along with any incoming U.S. economic data.

If both remain positive, profits for the S&P 500, as well as mid- and small-cap stocks, are likely to follow suit, driving the stock market upward.

Good investing,

Mike Burnick
Senior Analyst, TradeSmith

P.S. With promising forecasts for third-quarter earnings and fresh economic data surprising to the upside again, it’s a great time to be in the market… but it’s crucial to stay informed and be prepared for higher market volatility between now and the end of the year.

In market environments like these, volatility can leave you scrambling. Finding the right entry points for your new positions – and practicing appropriate risk management on your existing ones – can make or break your portfolio’s performance when the market really gets moving.

To make sure you’re prepared for any year-end market scenario, you’ll need to make sure you’re equipped with the right tools. And TradeSmith’s suite of portfolio management software offers everything you’ll need to conquer the end of this wild election year.

In earlier issues, I’ve written about the powerful tools and indicators available through TradeStops Pro – and how you can use them to help you navigate both the most challenging and the most favorable markets, with strategies and alerts tailored to your portfolio’s needs.

To discover all the ways you can use TradeSmith’s resources to safeguard and support your investments, click here.