Q3 Earnings Season Starts, Employment is Hot

During the past month, we’ve been discussing various recession indicators, as well as probabilities of the economy slumping into a recession. On Friday, the latest employment report from the Bureau of Labor Statistics (BLS) quelled any concerns of a near-term recession. 245K jobs were added in what has been a solid month for the labor market. Zerohedge notes that a record number of jobs came as a result of Government hiring:

“In September, the number of government workers as tracked by the Household Survey soared by 785K, from 21.421 million to 22.216 million, both seasonally adjusted (source: Table A8 from the jobs report). This was the biggest monthly surge in government workers on record (excluding the outlier print in June 2020, which was a reversal of the record plunge from the previous Covid collapse).”

Despite the various implications of government employment as a leading driver of job creation (socialism, anyone?), the fact is that the number of employed people is growing — and that means the economy continues to grow as well. For now, the near term risk of a recessionary downturn remains low. As a consequence, the Fed is in no hurry to cut rates faster than scheduled, as the probability of 50-bps easing next month has been eliminated. On the contrary, there is now a small percentage probability of “no cut” at the November meeting — 12.9%.

The equity market surged on Friday as a 2025 recession begins to be priced out. Volume was significantly below the recent average, however, suggesting that near-term upside may be capped. With stock prices near all-time highs and Q4 earnings season looming, it is understandable that investors would like to see some evidence of EPS growth first.

To be sure, median EPS growth for S&P 500 companies has lagged in the past 2 years. With the market advancing some +50% during the same timeframe (and +32% on an equal-weighted basis), earnings have remained flat.

Investors have been willing to pay more for the same amount of earnings, leading to the expansion of the median P/E Ratio. However, market gains as a function of expanding valuations can only go so far (especially in a restrictive interest rate environment). In order to get a continued rally, companies need to prove they are worth the valuation premium — by actually growing earnings.

Ahead of Q3 earnings season, we’ve already witnessed the common Wall Street analysts ritual of “lowering the bar so that everyone beats expectations”.

During the third quarter, analysts lowered EPS estimates in aggregate by a larger margin compared to recent averages. The Q3 bottom-up EPS estimate (which is an aggregation of the median EPS estimates for Q3 for all the companies in the index) declined by 3.9% (to $60.72 from $63.20) from June 30 to September 30.

At the sector level, nine of the eleven sectors witnessed a decrease in their bottom-up EPS estimate for Q3 2024 from June 30 to September 30, led by the Energy (-19.2%) and Materials (-9.4%) sectors. On the other hand, the Information Technology (+0.3%) sector is the only sector that recorded a (slight) increase in its bottom-up EPS estimate for Q3 2024 during this period. It is interesting to note that while analysts decreased EPS estimates in aggregate for Q3 2024 by nearly 4%, they lowered EPS estimates for CY 2025 by less than 1% (to $276.65 from $278.79) over this same period — FactSet

2025 EPS estimates are also just starting to be revised lower. Yet the market seems to “not care” and “defy gravity” for now — purely as a function of supply / demand dynamics. Of course, investors (especially the fundamentally driven ones) do not want to overpay for promised earnings growth that does not materialize, so we can understand their apprehension ahead of the coming earnings season which starts on Friday.

Technically minded traders as well as trend-following systems have all the reasons to remain bullish, despite the fragile fundamental underpinnings. In the short term, the breakout to new highs has completed a short-term technical “cup and handle” pattern — complete with a re-test — which suggests further upside with a year-end target of 600 on SPY.

And even using a longer term outlook, with optimistic assumptions about EPS Growth and the U.S. economy, the market does not seem especially expensive. (bear in mind, this scenario implies $280 S&P 500 EPS for 2025, which has already been revised lower, to $276 most recently)

It’s only when adjusting the technicals for a more “neutral” growth trend, using P/E ratios more closely aligned with historical averages, that we can visualize just where the current market is priced. In this case, a clear “ceiling” emerges, reflecting investor’s reluctance to push valuations further, without proof of accelerated growth.

Our Trading Strategy

Seasonally speaking, October is one of the more volatile months — especially ahead of the November 4 elections. Probabilities of positive returns are average, at around 60%. With Q3 earnings season ready to commence, and the bar being set quite high in terms of market pricing, there is ample room for disappointment.

The next couple of weeks will contain essential “show me” moments, as companies report earnings. We will either get fundamental confirmation that the outlook for 2025 is indeed optimistic and a fresh growth cycle is commencing, or earnings will yet again fall short of sky-high expectations.

We can surmise that the market is both at a fundamental and technical crossroads. Only time (and corporate earnings calls) will tell if we’ll get a “breakout” or “breakdown” going further, especially after the elections are all wrapped up. One thing is for certain in the current environment:

— “Sellers live higher. Buyers live lower.” —

With that in mind, we continue to practice risk management techniques, as stock picking and position sizing become essential in the month ahead. This week, we expect some volatility on Thursday and Friday, as inflation numbers are released and some of the largest Wall Street financial institutions report earnings (JPM, WFC, BLK).

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