Almost ninety percent of S&P 500 companies have announced their second quarter financial reports. Sales are up a mere 0.33% while earnings are down 8.21% through August 8th according to Bloomberg. Despite this, the S&P 500 continues to move higher in the third quarter. Several people have asked us why the markets continue to climb. We cannot know for sure, but there are a few reasons that make sense to us.
Inflation is falling fast, and faster than most investors and economists expected. At the same time, the likelihood of a recession occurring in the next two quarters has dropped. Many strategists and economists have stopped predicting the next recession and are instead expecting a soft landing. Declining inflation and a moderate growth backdrop have historically been positive for equity investors. Moreover, investor pessimism was high when 2023 began, while equity positioning was low setting the stage for the rally that unfolded. Reports have been mediocre, but second quarter revenues and earnings are 2.05% and 7.50%, respectively, better than estimates.
Earnings will likely have to grow for this rally to be sustainable. However, those who criticize 2023 gains as being solely due to multiple rerating need to explain why the market sold off in 2022 despite earnings growth. In the short run, the market is unpredictable. In the long run, sustainable earnings growth is required for markets to go up. As it stands, S&P 500 earnings per share have almost doubled in ten years. That works out to about seven percent compounded per year.
Another key point is that equity markets have gone up this quarter despite the sell-off in the two largest stocks, Apple & Microsoft, after they reported earnings. Markets frequently correct when leaders fall back, at least temporarily. Instead, the S&P 500 has paused as other companies have picked up the leadership baton.
Absent a recession or interest rates rising rapidly in the second half of 2023, this market is likely to continue moving higher, albeit at a slower pace. This does not mean investors should increase equity allocation targets nor do we think it is time to be defensive even though the S&P 500 is due for a pause or pullback. We expect the rate of appreciation to moderate as valuations have risen. It is appropriate to monitor and adjust portfolios, but we do not think wholesale changes are needed now.