Stock market highs are in, unless 3rd-quarter earnings clear this bar, analyst says

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It’s all eyes on earnings season, and the results that will begin to pour in heavily this week may determine whether the S&P 500 can press on to further records before year-end, says one closely followed Wall Street veteran.

“The companies of the S&P 500 need to beat by an aggregate 10 percentage points this quarter, or we’ve almost certainly seen the highs on U.S. equity markets for the year,” said Nicholas Colas, co-founder of DataTrek Research, in a Monday note.

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It’s been a torrid year for earnings, with first-quarter results topping estimates by 27 percentage points and second-quarter results beating by 17 percentage points, he said. That compares with an average beat of 3 to 4 percentage points seen in a typical quarter, and goes a long way toward explaining the S&P 500’s SPX, +0.04% year-to-date return of 17%.

Stocks were higher Monday, with the Dow Jones Industrial Average DJIA, +0.05% and S&P 500 both up 0.5%, while the Nasdaq Composite COMP, +0.21% rose 0.6%.

Colas illustrated his rationale in the chart below:

DataTrek Research

Colas noted that companies in the S&P 500 reported earnings of $53 a share in the second-quarter. If that ends up being the post-pandemic peak, then U.S. large-cap stocks are “clearly overvalued” at 21 times earnings (a 4,400 S&P 500 divided by $53 and multiplied by four).

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After all, Colas asked, “Who pays +20 (times) for declining earnings power? No one.”

So, the only way 21 times forward earnings would makes sense is if markets expect third-quarter earnings to exceed the second quarter.

“How much higher? It doesn’t have to be a lot; our baseline estimate is $54/share — just enough to show that U.S. corporate earnings power is still climbing and Q4 2021 and 2022 estimates are too low,” Colas wrote.

That alone shouldn’t cause bulls to sweat too much. Colas said it’s reasonable to expect S&P 500 companies to beat expectations by 10 percentage points, because Wall Street analysts never fully reset their estimates for the quarter, even after those consensus-beating first- and second-quarter results.

But the stakes are high, he said.

“We always hesitate to say that a given earnings season is the ‘most important ever,’ but Q3 2021 comes very, very close to justifying that sort of hyperbole,” Colas wrote.