Stocks that have reported weaker-than-expected third quarter earnings are seeing dramatic selloffs, dropping over 5% on average in the two days following results. This marks the worst performance after earnings misses since 2011, as rising interest rates expose companies unable to adapt to the new environment.
The data from FactSet on Tuesday showed S&P 500 companies that missed earnings per share estimates saw their stocks fall 5.2% on average in the subsequent two days. That’s more than double the five-year average decline of 2.5% and the steepest drop since the 8% plunge seen in the second quarter of 2011.
“Investors aren’t praising every single stock out there,” said Callie Cox, investment analyst at eToro US. “They’re really [homing in] on the fundamentals and trying to understand what benefits and what doesn’t in a high rate environment.”
This dynamic played out in the market on Wednesday, with stocks like Warner Bros. Discovery (WBD), Toast (TOST) and Upstart Holdings (UPST) tanking after weak earnings reports. Shares of these companies were down as much as 16% amid broad market declines.
Rising Rates Expose Vulnerable Companies
According to Cox, the severe stock reactions show that investors are being more discerning and identifying companies that could struggle the most with the Federal Reserve’s aggressive interest rate hikes.
One such company is Upstart Holdings, an AI lending platform whose stock plummeted 30% on Wednesday. Upstart posted a wider-than-expected loss of $0.05 per share in the third quarter. Revenue also dropped 14% year-over-year, and guidance fell short of estimates.
“In the third quarter, rates were at an all-time high in our marketplace, higher than we expected them to be, reflecting both decades high interest rates and significantly elevated risk in the consumer economy,” said Upstart CEO David Girouard on Tuesday’s earnings call. “This is not a path we would have chosen and is obviously not constructive to our growth.”
Upstart had been up over 400% earlier this year amid enthusiasm for AI stocks, but has since erased most of those gains. The company and other high-growth tech names are being impacted by the rising cost of capital.
Small Caps Hit Hard
The Russell 2000 index of small cap stocks, where many speculative growth companies like Upstart reside, has lagged the broader market in 2022. On Wednesday, the Russell 2000 was down over 1.2%, compared to a 0.5% drop in the S&P 500.
“It’s important as an investor to really understand what kind of risks you’re taking on because companies are getting hit hard by higher interest rates, especially smaller speculative companies,” Cox noted. “You see that flow through in events like earnings and management calls. The effects [of higher rates] become more apparent.”
Even large cap stocks have suffered after disappointing results. Warner Bros. Discovery, the media giant formed from the merger of Discovery and AT&T’s WarnerMedia unit earlier this year, saw its stock plunge 17% on Wednesday.
The company badly missed subscriber estimates for its new streaming service and reported a large loss in the third quarter. Management also warned that economic challenges could worsen in the coming year.
Fed Remains Hawkish on Rates
The Federal Reserve has been aggressively raising interest rates this year in an effort to combat surging inflation. But the central bank’s actions have also tightened financial conditions and increased concerns about a potential recession.
In their November policy statement, Fed officials stated that ongoing rate hikes would be appropriate to return inflation to their 2% target. The Fed’s benchmark rate currently sits at a range of 3.75% to 4% after starting the year near zero.
According to the CME FedWatch tool, markets are pricing in a 77% chance that the Fed hikes rates by another 50 basis points at its December policy meeting. Further rate increases are expected in early 2023 even as the economy slows.
This outlook has put pressure on stock valuations, especially for companies that rely on cheap financing to fuel growth. Additional large market selloffs could occur if earnings continue to disappoint in the fourth quarter.
Investors Rewarded for Caution
With the Fed publicly committed to tackling high inflation regardless of economic consequences, analysts say a cautious stance is warranted.
“It’s been an incredibly humbling year for tech investors, and the fundamentals matter once again,” said Dan Ives, analyst at Wedbush Securities. “In this tape, you need to stick with higher quality, profitable tech names with good fundamentals.”
Companies that have beat earnings estimates and provided strong guidance have generally seen their stocks rally after reporting. This environment is rewarding investors who pay close attention to the details and avoid unprofitable, speculative companies.
But significantly more downside could still emerge for the broader market if consumers pull back spending and corporate profits take a hit. The Q3 earnings season is only about halfway done, with many major companies still left to report.
Investors braces themselves for more big swings in stock prices as rates remain high and uncertainty lingers over the economic outlook.