Earnings season begins with a focus on guidance. 

It’s a cliché, but it’s true:  Investors are focused on the future, not the past. 

But it’s even more true for 2022 than most other years.

Fourth quarter earnings for the S&P 500 are expected to be up 22.4%, according to Refinitiv, capping off a remarkable 2021 where overall earnings will be up approximately 49%.

Don’t expect that to last.

Investors will be dealing with three major issues that will affect corporate profits: consumer demand, profit margins, and Fed policy.

Two of those factors — profit margins and Fed policy — are likely to be serious headwinds.

Earnings reporting season kicks of this week with Delta on Thursday and a bunch of banks on Friday.

The good news is that consumer demand remains strong going into 2022.  Although spending appears to have moderated a bit recently and supply chain issues will continue to surface in corporate commentary, omicron is expected to slow but not derail the economic recovery.  The wild card is whether the withdrawal of stimulus will cause the consumer to pull back in the second half of the year.

This is the critical component of corporate profitability, since it measures how much profit a company is able to retain after paying costs.  S&P 500 operating margins have remained close to a record 13% through most of 2021 because corporations, while faced with higher costs, were able to raise prices.

Corporations may not be so successful in 2022 at maintaining those margins, even if commodity costs come down.

“We see corporate profits at risk amid rising wage pressures” Savita Subramanian, Bank of America’s Equity & Quant Strategist, said in a recent note to clients.  She noted that labor costs were roughly 40% of total costs for corporate America.  She expects continuing upward wage pressures to continue and says it is likely “wildly unrealistic” to expect margins to remain at records for 2022. 

It all comes down to whether companies can continue to raise prices, which is problematic after a year of big price hikes:  “If wages are sticky, pricing and demand will determine the have vs. have-nots,” she wrote.

“The Fed is raising interest rates in an environment where earnings growth is decelerating,” Nick Raich, who tracks corporate profits at the Earnings Scout, told me. 

While the Fed raising rates gradually in a strong economy may not be a problem, it could be a problem when the Fed actually starts raising rates in the second quarter, especially if there is a sign that the economy is slowing down. 

The Fed raising rates in a declining economy is definitely a problem.

“I’m worried about Q2 and Q3 estimates, because they don’t have rate hikes baked into them,” Raich told me. 

Why not?  “Because the analysts are mostly just listening to what the companies say,” and the companies have not yet begun to talk about the impact of higher rates in 2022.

But the stock market has already sniffed out that concern.

Aside from macro issues, there are several other early warning signs that indicate 2022 may be a bit tougher than 2021.

One excellent sign of future stock prices:  analysts that are raising estimates.

While expectations of future earnings are what matters, it is changes in the trend that moves stocks. “It’s the change to the expectations that matter most,” Raich told me.  “It’s what expectations are out six to 18 months from here.”

In 2021, most of the earnings estimates were rising through the year, providing a significant tailwind for stocks.

That isn’t happening now.  Fourth quarter estimates, for example, remained flat at roughly up 22% for several months. 

“For stock prices to justifiably go higher, EPS estimates must rise at increasing rates too,” Raich said in a note to clients earlier this week.  

“This is not happening anymore.”

 A second red flag:  early reporters are not beating estimates the way they used to.

 2021 was a strange year for earnings.  Analysts consistently underestimated the strength of the economic recovery.  As a result, earnings were often 20% higher than analysts were expecting.

 They may not continue into 2022.

 To date, 20 companies have reported earnings.  Most of these have quarters that ended in November.

 Those 20 are beating earnings by an average of 13%.  Those 20 were beating by 20% in prior quarters.

 The final factor argue for a moderation is simply gravity:  After several whacky years, earnings will likely experience mean reversion, the tendency to revert to long-term averages.

 Average earnings growth in the S&P 500 is typically in the mid- to high- single digits.

 Not surprisingly, that is exactly what 2022 is shaping up to look like:

 S&P 500:  2022 earnings estimates

• Q1:   up 7.6%
• Q2:   up 5.2%
• Q3:    up 7.4%
• Q4:    up 14.3%

Source:  Refinitiv

Given that 2021 Q4 numbers are likely to come in higher than expected, that 14.3% increase for 2022 Q4 estimates will likely come down as well.

The bottom line:  Overall earnings for 2022 are likely to be in the mid- to high single-digit numbers, about in line with historic averages.

 ”You had big earnings growth in 2021, so now we are going back to normal.  It’s 49% growth [for 2021] that is abnormal.”