Stocks finally snapped a three-week streak of losses. Whether they can keep up their recovery may depend in part on how earnings season plays out next month.
Analysts have cut their estimates for third-quarter earnings growth by 5.5 percentage points since June 30, according to John Butters, senior earnings analyst at FactSet. That is more than usual and marks the biggest cut since the second quarter of 2020, when the Covid-19 pandemic and ensuing lockdowns brought economic activity to a standstill.
Companies also have been looking increasingly pessimistic lately. A total of 240 companies in the S&P 500 mentioned recession on their postearnings conference calls for the last quarter, the most ever in FactSet's data going back to 2010.
Even with the outlook for the coming earnings season darkening, markets have been resilient. That is in part because companies are still expected to report modest earnings growth through the rest of the year, and other data points such as employment and consumer spending have continued to show strength in the economy. Yet investors and analysts caution that stocks' recent gains look vulnerable, should data take a turn for the worse in the coming months.
"You've got this really unpleasant combination of very high inflation, an economy that's already slowing down, and a central bank that's tightening policy rapidly," said Dave Grecsek, managing director in investment strategy and research at Aspiriant.
Stock valuations also remain elevated, Mr. Grecsek said.
The S&P 500 trades at 17 times its next 12 months of expected earnings, according to FactSet. That is below its five-year average, but above where it was at the end of the second quarter, due to the fact that stock prices have risen while earnings estimates have fallen.
"All things considered, it doesn't really feel like a good time to be adding risk here," Mr. Grecsek said.
The S&P 500 is down 15% for the year, despite its last week of gains and its brief summer rally. The Dow Jones Industrial Average remains down 12% for the year.
To be sure, companies have largely proven to be more resilient in the face of slowing growth and high inflation than investors feared.
Home improvement retailer Home Depot Inc. last month reported record earnings and revenue for the second quarter, thanks in part to consumers spending more on every transaction than they did a year ago.
The consumer "has been more resilient than we even expected in the beginning of the year," said Richard McPhail, the company's chief financial officer, on its earnings call.
Other companies heavily focused on consumers, such as Dick's Sporting Goods Inc., Walmart Inc. and Kroger Co., also have posted stronger-than-expected earnings.
What many investors fear is that, eventually, companies that have been able to weather rising costs by raising prices for their goods and services will be less able to do so as the Federal Reserve keeps tightening monetary policy. The Fed has said it is determined to bring inflation down through its interest-rate increases, even if it comes at the expense of economic growth.
"If your revenues are going down, but costs for labor, materials and other things are still challenging, that could be a real headwind to earnings," said Anujeet Sareen, portfolio manager at Brandywine Global.
Mr. Sareen says his team has been generally reducing exposure to riskier assets this year and focusing on companies whose balance sheets look strongest.
So far, the decline in earnings estimates hasn't been big enough to put companies on course for losses. S&P 500 companies are still expected to post earnings growth of 3.7% for the third quarter, according to FactSet. That would mark the slowest pace of growth since the third quarter of 2020.
While some investors have seen falling earnings estimates as a foreboding sign, Jonathan Golub, chief U.S. equity strategist at Credit Suisse, says in periods of high inflation, earnings have historically peaked just two months before the start of a recession.
That means earnings estimates would have to fall much more for them to signal an economic downturn was imminent, he said.