Key Questions: Q4 Earnings Recap “What Did We Learn From Fourth Quarter Earnings?”

Earnings reporting season for the recently ended quarter is nearly complete, and between the flood of activity from the new presidential administration and the emergence of a potential breakthrough moment in artificial intelligence (AI), it has been an extremely eventful one. We analyzed dozens of such reports and identified three key themes that best summarize the quarter.

1. The New administration is creating opportunities and challenges
2. Earnings reports and guidance data are fairly normal, all things considered
3. Breakthroughs in AI are potentially reshuffling the winners and losers
    

New administration creating opportunities and challenges

As the Trump administration took office, it immediately began to roll out policies promised on the campaign trail. While nothing thus far has been a surprise relative to expectations, the actual implementation of some of these policies has created additional operational and forecasting challenges for companies.

The most far-reaching set of proposals has been surrounding tariffs. The use of tariffs was widely expected, as we discussed in our 2025 Outlook, but which countries and industries would be targeted first was up for debate. Therefore, when news broke that Canada and Mexico would be hit with 25% tariffs with minimal exemptions, it caught many off guard. Companies hurriedly formulated forecasts to assess the potential impact, only to learn later that these tariffs would be postponed.

These twists and turns in tariff policy generally caused management teams to exclude the potential impact from 2025 guidance given the heighted uncertainty of what tariffs will go into place and how long they will last. To quell investor concerns, management teams spoke about dusting off the tariff playbook from Trump’s last term to mitigate the impacts. While we have no doubt that companies will do whatever they can to protect profits, if tariffs are implemented, it would be unwise to assume there will be some impact, including higher prices leading to some demand destruction. These factors lead us to believe that if the tariffs do go into effect and stay in place for an extended period of time, company forecasts and analyst earnings estimates will likely have to come down.

Positively, potential deregulation has many management teams feeling more optimistic about the business environment going forward. Reducing government oversight and regulatory burdens may help companies reduce costs and increase agility. Mergers and acquisitions are another area where activity is expected to accelerate, as the administration is expected to have a lower bar to clear to achieve approval. Increased M&A could result in increased cost and revenue synergies for the newly combined entities, which could in turn have a positive impact on earnings growth rates.

Earnings reports and guidance data are fairly normal, all things considered

Along with participating in earnings calls, we look through the data to try to identify trends that can help us formulate market-, sector-, and company-specific views going forward. From a high level, 77% of companies in the S&P 500 that have reported results “beat” (i.e., exceeded analyst forecasts) estimates for the fourth quarter of 2024. This matches the five-year average “beat” rate of 77%. This is more a backward-looking report card that tells us that the final quarter of 2024 unfolded generally how the market expected.

However, only 44% of S&P 500 stocks of the companies that reported results experienced a positive price reaction one day post-reporting, compared to a three-year average of 51%. This tells us that even though fourth quarter results were in line with expectations, forward guidance has disappointed, on average. Earnings growth expectations for 2025 were high coming into earnings season, with expected year-over-year growth of 14.7%, roughly twice the 10-year average annual earnings growth of 7.7%. Thus far, the growth rate for 2025 has moderated to 13% year over year, indicating that expectations may have been a little too high to start the year.

We looked on a sector-by-sector basis to better understand what areas were driving these downward revisions to the growth forecast. Since December 1, 2024, Financials is the only sector that has seen earnings estimates move higher. The three most negative sectors were all cyclicals: Energy, Materials, and Industrials. The seven remaining sectors were all down very modestly.

It is no secret that the Magnificent 7 stocks have been driving a large portion of the overall index returns the past few years, so we thought it would be helpful to look at historical and future earnings growth expectations for these stocks versus the rest of the index to help inform whether this market dominance can continue. In 2023 and 2024, “Mag 7” earnings growth was 32% and 35%, compared to the rest of the S&P 500 of 4% and 1%, respectively. In 2025 Mag 7 earnings growth is expected to be 19%, while the rest of the index is expected to grow 11%. We believe these growth rates converging is the sign of a healthy market. And as earnings growth broadens out, so should price performance for the rest of the market.

Breakthroughs in AI are potentially reshuffling the winners and losers

Last month, the news that Chinese AI company Deepseek developed an AI model comparable to leading U.S. AI models at a fraction of the cost sent shockwaves through the financial markets. Given the timing of this announcement, we were able to analyze earnings calls to get a real-time look at how management teams plan to respond to this new information. The most positive cohort was software companies. If AI costs indeed turn out to be much lower than initially planned, and writing code and providing services could be done in a more cost-effective manner, innovation could occur at a faster rate. This could have a positive effect on both growth rates and margins.

While investors have been quick to reset positions to reflect views on future winners and losers, management teams have taken a more measured approach. The companies involved with providing the computing power for AI models on the surface appear to be the most impacted if less power is in fact required. However, the general theme has been to march ahead with investment and growth plans in the face of these new developments. As the landscape rapidly shifts, only time will tell whether these investments will make a satisfactory return for investors.

Conclusion

In summary, equities have been positive year to date despite added uncertainty and declining earnings growth expectations. These returns have been driven by more than just a few large companies, which points to the market being in a healthy place. For this positive performance to continue, earnings expectations will likely need to hold steady or improve from here.

For more information, please contact your advisor.