How Q3 earnings could lead to a narrative shift in the stock market

Stock market performance will be worth keeping an eye on as we head into third-quarter earnings season, in which results are expected to be more muted than in the second quarter. (AP Photo/Richard Drew, File)

Richard Drew/The Associated Press

Corporate earnings have been growing at a rapid rate since the first set of COVID-19 lockdowns in early 2020, as the economy continues its path to recovery. Yet, financial advisors and investors need to remember that there are always limits to growth.

Year-over-year earnings growth for the S&P 500 Index during the second quarter (Q2), ended June 30, was reported to be 96.3 per cent, according to Refinitiv data. That’s a huge growth rate and largely the result of using corporate earnings from the depressed Q2 2020 as a basis of comparison. Although Q3 earnings growth is expected to remain strong, at 29.4 per cent on a year-over-year basis, the result is significantly more muted. In fact, year-over-year growth rates are expected to continue to contract until Q2 2022.

Even though corporate earnings are likely to continue to grow and not turn negative, the issue is that investors have become accustomed to hearing about rapidly rising earnings growth rates. When the trend is heading higher at an accelerating pace, “anything is possible.” When the trend changes and the growth in quarterly earnings starts to decline, the narrative in the stock market can shift quickly from positive to negative.

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When a trend is accelerating higher, it’s easy to envision the trend continuing into the future. That’s what recency bias – a cognitive phenomenon that humans share in which we predict the future based upon recent trends – is all about. As a result, when the earnings growth rate starts to slow, investors will wonder if it will continue down that path and if growth will even lead to contraction. Once peak earnings growth has passed, investors will start to have doubts about future earnings growth.

This year, stock market performance will be worth keeping an eye on as we head into Q3. On a seasonal basis, the S&P 500 tends to perform well in the first 18 calendar days in October as investors anticipate positive earnings to boost the stock market.

The premise behind this seasonal trend is that investors generally want to be invested in the stock market ahead of earnings season so that they will be positioned for any positive surprises when earnings are announced.

From 1950 to 2020, the S&P 500 has produced an average gain of 0.8 per cent and has been positive 66 per cent of the time during those first 18 days of October. Will this trend continue this year? Will investors have one last kick at the can and push the stock market higher heading into Q3 earnings season? Or will they start to anticipate weaker earnings growth in the future?

Earnings have generally beaten expectations by a wide margin in the COVID-19 recovery. According to Refinitiv data, 88 per cent of the companies beat their earnings expectations in Q2. This outperformance has been fairly typical during this economic recovery. However, if fewer earnings reports beat expectations when corporations start reporting their Q3 earnings, investors could become anxious about the level of future earnings and start to exit the stock market.

No one knows exactly how the Q3 earnings season will play out. If the stock market breaks with its seasonal trend of performing well in early October before the earnings season gets into full swing, this could be a sign that investors are concerned about the upcoming earnings season. That would not be a good sign for the stock market, and the stock market could falter unless the earnings are much stronger than expected when they start to be released in the middle of the month.

The U.S. banks’ earnings releases are unofficially considered to be the kick-off for quarterly earnings season, as they are some of the first companies to release their results. JP Morgan Chase & Co. JPM-N, Goldman Sachs Group Inc. GS-N, Wells Fargo & Co. WFC-N, and Bank of America Corp. BAC-N all are expected to release their earnings on Wed. Oct. 13.

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Investors’ reactions to these bank earnings can help set the tone for the first part of the Q3 earnings season. If investors react negatively to the earnings releases, this can put a damper on a potential stock market rally. If investors react positively, this can help set the ground for the stock market to move even higher.

A big risk to the stock market is if Q3 bank earnings and other company earnings fall short of expectations. If this were to happen in combination with a declining growth rate for earnings, investor anxiety could ratchet up quickly and the stock market could move into correction mode as a result.

This earnings season, investors’ reaction to earnings is particularly important as the expected declining growth rate for earnings could provide fertile ground for a narrative shift in the stock market.

Brooke Thackray is a research analyst at Horizons ETFs (Canada) Inc. He focuses on technical analysis and seasonal investing.