Wall Street is not optimistic about the earnings season. Can the bull market in US stocks continue?

This week, US stocks face a new round of tests as the Q2 earnings season kicks off. The outlook for corporate profits is not optimistic, and it remains to be seen whether the strong upward trend in the first half of the year can continue.

Wall Street analysts are not optimistic, expecting S&P 500 companies to experience a third consecutive quarter of declining profits. According to FactSet data on Monday, profits in the second quarter are expected to decline by 7.2% YoY, the largest drop since the second quarter of 2020.

In the first half of this year, US stocks ignored deteriorating profit expectations, with the S&P 500 index rising 15% and the NASDAQ Composite Index rising 31%, marking the best start in 40 years.

Meanwhile, US companies are grappling with persistent inflation, tight consumer demand, and the Federal Reserve's interest rate hikes. Investors are eagerly awaiting the next round of earnings reports to assess corporate profits and determine whether stocks are overvalued.

This week, Wall Street will kick off the earnings season with reports from major players such as JPMorgan Chase, Wells Fargo, Citigroup, BlackRock, and PepsiCo.

Earnings season puts pressure on US stocks, AI's impact on profit improvement exaggerated

According to Deutsche Bank strategists, earnings seasons have typically been favorable for stocks over the past decade. However, according to a survey of 346 respondents by MLIV Pulse, 55% of people believe that the upcoming earnings season will pose a threat to the stock market. Respondents believe that the impact of artificial intelligence on the profitability of the technology industry has been exaggerated, while financial tightening has hurt company profits.

42% of respondents believe that the biggest negative impact of the earnings season will be further tightening of financial conditions. The optimism surrounding the current soft landing of the economy is dissipating, as last week's non-farm payroll report showed wage growth continuing to outpace expectations. The possibility of a Fed rate hike in July remains high, putting pressure on market sentiment.

Sophie Lund-Yates, Chief Equity Analyst at Hargreaves Lansdown, said:

The negative noise from the earnings season will certainly slow down this runaway train that is the US stock market, especially when economic indicators suggest further rate hikes in the future.

Furthermore, although the rise of technology stocks has been driven by hype around AI, over 70% of survey participants believe that the impact of artificial intelligence on tech stock returns has been exaggerated. This makes companies leading the development of AI, such as NVIDIA and Microsoft, more susceptible to stock declines when their earnings disappoint investors.

Will profits improve in the second half of the year?

However, analysts are relatively optimistic about earnings for the remainder of 2023. According to FactSet data, analysts expect S&P 500 companies to see a profit growth of approximately 0.3% in the third quarter and approximately 8% in the fourth quarter.

One key question for investors is how long companies can sustain profits by attempting to pass on rising costs to customers, who have already endured price increases for several quarters. Analysts predict a 0.3% YoY decline in revenues for S&P 500 companies in the second quarter, marking the first decline since the third quarter of 2020. Overall, compared to the surprising earnings in the first quarter, the financial report for this quarter appears more bleak. Mislav Matejka, strategist at J.P. Morgan, stated that profit margins will face pressure as the company loses the ability to continue raising prices when inflation cools and growth slows.

If profits continue to decline, it could make stock valuations appear more expensive relative to the company's earnings. Investors typically use the price-to-earnings ratio as a measure of whether a stock is cheap or expensive. The price-to-earnings ratio for companies in the S&P 500 index is currently around 19 times earnings for the next 12 months, higher than the 17 times at the beginning of the year and higher than the five-year average of 18.6.