Stocks could suffer their biggest correction since the 2022 bear market if gains take off, analysts say. Here’s what investors should pay attention to.

• Second-quarter earnings season could lead to the most painful stock correction since 2022, according to NDR.

• The research agency warned of a shift from accelerating to decelerating growth towards 2025.

• “A high strike rate may be needed again to justify the rally,” analysts said.

Earnings season officially started this week, and it could trigger the most painful correction for stock prices since the 2022 bear market.

That’s according to research from Ned Davis Research, which offered a preview of what will matter most in the coming weeks amid the flurry of second-quarter earnings.

“The biggest risk could be a shift from accelerating to decelerating annual/year growth towards the end of 2024 and into 2025,” NDR strategist Ed Clissold said in a Thursday note.

That means that no matter how strong this quarter’s earnings results are, the future success of the stock market will largely depend on the business outlook for the second half of the year.

Here’s what investors should pay attention to during second-quarter earnings season, NDR said.

Growth estimates for the second half

The typical trend for earnings growth estimates on Wall Street is to be overly optimistic at the beginning of the year, then slowly revised downward toward the end of the year.

Therefore, the question is not whether analysts will cut their second-half earnings growth estimates, but rather by how much they will cut them.

“Last year the growth rate was adjusted downwards by 4.8 percentage points, much less than the long-term average of 8.1%. It’s one of the reasons the S&P 500 rose 24.2%. So far, the consensus in 2024 has only been revised down 1.3%, again one of the reasons for the 18.1% gain since the start of the year,” Clissold said.

Current analyst projections point to S&P 500 earnings growth of 5.7% in the second quarter, 19.2% in the third quarter and 19.6% in the fourth quarter.

And those rosy growth estimates could ultimately cause the stock market to tank, especially given expectations for a slowdown in the growth rate of the U.S. economy in the second half of this year.

The consensus earnings are correct

Since the start of the now 18-month bull market, at least 78% of stocks have risen S&P500 companies have exceeded consensus estimates, which are historically high.

That trend of width inwards corporate profits will have to continue if the next inevitable stock market correction will be carried even further.

“A high strike rate may still be needed to justify the rally,” Clissold said. “Management teams reduced year-over-year growth in the second quarter to 5.7% from 7.0% at the end of May. The lower bar makes a high success rate more achievable.”

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Accelerate growth

“The concept that earnings growth is good for stocks seems intuitive. That’s true, but with an important caveat. Investors look ahead and often view extremely strong annualized earnings growth as unsustainable,” Clissold said.

With earnings growth soaring in recent quarters, how sustainable that growth rate is remains a key question for investors, as slowing growth is rarely rewarded with higher stock prices.

“Earnings are in a sharp acceleration phase and consensus estimates call for them to remain there through the third quarter. During the second quarter earnings season, watch to see if the expected year-over-year acceleration in earnings per share pays off and how long this may last.” Clissold said.

The beautiful 7 shares

Much of the S&P 500’s earnings growth has occurred since this bull market began was driven by a handful of mega-cap tech companies like it Nvidia, AmazonAnd Metaplatforms.

“Five of the seven grew at least 20% versus the first quarter of 2023, and three grew at least 100%,” Clissold said of the mega-cap tech’s earnings growth.

As strong as that growth has been, it sets the bar high for these companies to continue delivering growth quickly enough to impress investors.

“The hurdle is high. The consensus calls for five members of the Mag 7 to post slower growth rates in the second quarter than in the first quarter. Even strong growth rates may not be enough to keep Mag 7’s growth rates accelerating” , said Clissold.

The remaining 493 shares

To keep the bull market going, the remaining 493 S&P 500 stocks need to start pulling their weight when it comes to earnings growth, and this earnings season could be the quarter when that finally happens.

The 493 companies are expected to grow their profits by 1.1% in the second quarter, compared with first-quarter expectations of a decline of 5.7%. These companies ultimately posted first-quarter earnings growth of 0.3%.

“Analysts expect the Mag 7 to continue to drive earnings growth, but the rest of the market will participate more. The bar is noticeably lower outside the mega-cap favorites,” Clissold said.

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