Slowing Earnings Estimates Could Trip Up SPY Stock

The S&P 500 is on a winning streak following its recent correction. After falling 14.6% from peak to trough earlier this year, the broader market index has rebounded 10% in the past two weeks. As you’d expect, the exchange-traded funds (ETFs) that track the index, such as the popular SPDR S&P 500 Trust (NYSEARCA:spy), have also enjoyed swift reversals.

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It’s possible the bulls may be getting ahead of themselves, though. There are some clear-and-present risks to the market — eg, inflation, Federal Reserve rate hikes and the war in Ukraine — that traders seem to be overlooking as they snap up stocks.

Even if we assume the worst is over in terms of those headline risks, there is still reason for skepticism toward SPY stock going forward.

The Reopening Trade Starts To Fade

Since March 2020, investors have primarily focused on the eventual end of Covid-19, or at least the end of its disruption of the economy. There were things to look forward to, such as stimulus programs, vaccines and various economic growth markers on the path to normalization. Indeed, in 2021, the US economy grew at its fastest pace since 1984, as people went out and spent on consumer goods and experiences at a frenetic pace. But this momentum is unlikely to make it far into 2022.

Soaring gasoline prices are hitting consumers’ wallets. The average price of gas is nearly $4.25 per gallon and could top $4.50 or even $5 this summer if oil remains at elevated levels. Money being spent at the pump is not going to other parts of the economy.

In addition to higher energy costs, soaring inflation means consumers are facing rising costs in most other aspects of their lives. Rising food prices, in particular, threaten to put a big dent in working families’ budgets. This will only be exacerbated if the war in Ukraine continues, threatening an important part of the world’s grain production.

Inflation is hitting corporate earnings more directly as well. Soaring labor costs are crimping profit margins. Surging input costs from things like energy and basic materials could translate to lower profits even if sales hold up. Throw in declining demand as consumers are forced to rein in spending and we could see a sizable decline in corporate earnings in the latter half of 2022 and into 2023.

Analysts Lowering Earnings Estimates

These macroeconomic headwinds are starting to show up in the data. A recent analysis from FactSet showed the largest decline in earnings estimates for the 500 constituent S&P companies since the second quarter of 2020, at the height of the initial Covid-19 shock.

S&P 500 companies have enjoyed consistently stronger earnings as the economy has reopened. And it’s not just that earnings have gone up in absolute terms. Importantly, estimates for future earnings also were going up. In that optimistic environment, traders had good reason to buy any and all dips in the market.

Now, however, the earnings story is showing its first cracks. Sure, a projected 1.2% decrease in FactSet’s Q1 bottom-up EPS estimate for Q1 2022 is hardly the end of the world. As FactSet notes, it’s smaller than the average decline for the same period over the past five, 10 and 15 years.

However, in the latest Earnings Insight report, of the 95 S&P 500 companies that have issued EPS guidance for the first quarter, 66 have issued negative EPS guidance, the most for a quarter since Q4 2019.

With stock valuations still high, earnings misses and lackluster guidance could result in sharp sell-offs. We’ve already seen that phenomenon play out in a number of software stocks over the past six months. And it may spread to the rest of the S&P 500 this summer and fall.

SPY Stock Verdict

Over time, the vast majority of the stock market’s performance is related to earnings growth. Investors tend to value companies on earnings directly, such as through the price-to-earnings ratio. They also value companies based on factors that tend to be closely linked to earnings, such as free cash flow and dividend yield.

For investors to make a positive return owning stocks, earnings need to go up and/or valuation ratios need to expand. In a roaring bull market, both often happen at the same time. Without earnings growth, however, investors have to rely solely on valuation multiples to rise. With the S&P 500 already well above historical valuation ratios, don’t assume that the market’s price-to-earnings ratio will climb even higher.

In the short run, stocks can go anywhere. Momentum is a powerful thing, and bulls have had the winds at their back since 2009 with only brief exceptions. However, with the earnings growth engine running out of steam, this market rally could be on its last legs. Investors in SPY stock and similar index ETFs should be aware of the mounting risks in the market.

On the date of publication, Ian Bezek did not have (either directly or indirectly) any positions in the securities mentioned in this article. The opinions expressed in this article are those of the writer, subject to the InvestorPlace.com Publishing Guidelines.

Ian Bezek has written more than 1,000 articles for InvestorPlace.com and Seeking Alpha. He also worked as a Junior Analyst for Kerrisdale Capital, a $300 million New York City-based hedge fund. You can reach him on Twitter at @irbezek.

Ian Bezek has written more than 1,000 articles for InvestorPlace.com and Seeking Alpha. He also worked as a Junior Analyst for Kerrisdale Capital, a $300 million New York City-based hedge fund. You can reach him on Twitter at @irbezek.

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