Looking At: Thoughts on Earnings Season

Estimated reading time: 6 minutes

Mind Your Margins

With most economic data releases on hold due to the government shutdown, company earnings may have even more of an impact on market direction than usual. And as we get ready to kick off the third-quarter earnings season, it’s expected to bring another strong set of results.

One of the datasets that will be critical to watch — not only this earnings season but in the quarters to come — is profit margins (i.e. revenue minus costs). There has been a persistent debate among investors around the possible effect of tariffs on company results, and this is the quarter when we may start to get a clearer view of whether they’re taking a bite out of margins.

Coming into earnings season, margins are slightly above trend for the S&P 500. That’s certainly a strong starting point, and provides a decent buffer to absorb any compression due to tariffs. 

S&P 500 Profit Margin

From a sector perspective, some of the strongest margins are expected to come from technology and communications, which would offer more fundamental support for their strong performance year-to-date. Coming in closely behind those two is the financials sector, which has performed well this year but could still have room to run as investors seek opportunities outside the AI-driven sectors.

Although one would expect tariffs to impact the goods sectors outside of technology, communications, and financials, the health of margins from a broad index perspective sets us up to remain steady in the face of those possible headwinds.

The Usual Suspects and One Dark Horse

Once again, the story for the third quarter is expected to highlight technology stocks as the earnings leaders. Year-over-year growth is expected to come in at 30%, far above any other sector in the index. 

When we look at things for full year 2025, the “usual suspects” — technology and communications — are expected to be the standouts, with 21% and 18% earnings growth, respectively. The “dark horse” is health care, which is expected to have the third-best growth for the year (higher than the broad index earnings growth), despite unimpressive growth in the third quarter. For a sector that’s only returned 6.6% YTD (most of which has come in the last month), it could offer solid opportunity as the fundamental story shows signs of life. 

Consensus EPS Growth

The major market moving headlines of earnings season continue to revolve around forward guidance, and more specifically, guidance on AI-related spending from technology companies. 

If the trend below continues at this clip, we should expect to hear about more and more spending at least through 2026. The tricky part about interpreting those messages is that the growth rate in spending is expected to slow in 2026 to only 21%. That could shift the focus onto profits generated from said spending, but is more likely to be a topic later this year or early next. As we get guidance for the remainder of this year, I’d expect the spending spree to remain intact.

Hyperscaler CapEx Consensus

Cues from Quality

Since the volatility in April of this year, low-quality stocks have outperformed high-quality stocks by 14%. That comes as no surprise since markets have enjoyed a risk-on rally for the last few months, with the S&P 500 +35% since the low on April 8. 

There’s no telling how long the rally will go on, but it’s important to note the typically inverse relationship between low-quality stock outperformance and earnings growth. When earnings are strong and rising, low-quality stocks tend to outperform high-quality stocks. But as we know, markets tend to sniff things out slightly ahead of an actual trend change. 

The chart below shows high-quality versus low-quality performance (red/blue line) and S&P 500 earnings (black). We’re in a period where earnings have been very strong, and low quality stocks are winning. If and when the market sniffs out a weakening earnings trend, I would expect to see high quality stocks start to perk up. That hasn’t happened yet, but it’s something to keep a pulse on through earnings season and beyond. 

Quality Factor Inversely Correlated With Earnings

In conclusion, third-quarter earnings season looks to be another set of strong results with companies likely surpassing expectations broadly. If that ends up being the case, the rally has further support and the already high valuations of many stocks can remain high. At some point, spending is likely to slow and guidance may become more muted. Also at some point, earnings may soften and markets will need to digest a slower pace of growth. We don’t expect either of those to ring true for the third quarter, so the optimism in markets is likely to stick.

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