Corporate earnings season shifts into high gear on January 14 when the financial sector unofficially kicks off the Q4 2021 reporting period.

That means that as of Friday, the investing and trading world will have a chance to review recent quarterly performance at some of the country’s leading financial institutions, including Blackrock (BLK), Citigroup (C), JPMorgan (JPM) and Wells Fargo (WFC).

It’s expected that the financial sector will unveil solid results on an absolute basis, but marginally less impressive relative to the first half of 2021.

Overall, consensus expectations suggest that companies in the S&P 500 grew their earnings at a rate of about 20% during the fourth quarter of 2021, on average. That’s a lot better than the anemic earnings growth observed in 2019, and during 2020 when corporate profitability was ravaged by the onset of the COVID-19 pandemic.

But going forward, as illustrated below, corporate earnings projections for 2022 are looking far less rosy.

The above data suggests that investors and traders will likely be following the current earnings season closely, as many companies will be providing full-year 2022 earnings guidance in their forthcoming releases. Such projections are arguably even more important to investors and traders than past results.

And as most market participants are well aware, corporate earnings are intimately linked with stock valuations because the price of a stock is often founded on earnings expectations/projections for a given company. Therefore, when companies release their quarterly earnings and ongoing financial projections, prices in the market usually fluctuate—sometimes significantly.

Earnings have been particularly interesting during the COVID-19 pandemic because this data has allowed market participants to gauge the relative impact of the pandemic on the wide spectrum of market sectors and companies within the economy.

Last year, the big question was how corporate earnings might rebound after an endless series of economic shutdowns ravaged the global economy in 2020.

But this year, most market participants are watching for insights into the nature of the post-pandemic world. Considering the rapid pace of inflation last year, the ongoing impact of rising prices on corporate profitability will also be an important narrative to monitor.

The stock market has already kicked off 2022 on shaky footing, so the complexion of Q4 earnings will also undoubtedly play a key role in dictating where things go from here.

S&P 500 Price/Earnings Ratio (P/E Ratio)

Another important metric that investors and traders can use to monitor the health of corporate earnings (and associated valuations in the stock market) is the S&P 500 Price/Earnings Ratio (P/E Ratio).

The P/E Ratio is calculated by taking the average stock price of large-cap stocks in the S&P 500 Index and dividing that collective price by the respective mean earnings of those companies. The quotient of that calculation typically equates to what many refer to as the P/E of the market.

This figure is important because it can be tracked over time, and since the early 1900s, the average P/E for the market has hovered right around 17.

When the market’s P/E rises above 17—especially to an extreme degree—some market pundits start to worry about overvaluations. The same can be said when the market’s P/E drops below 17, although in that case, the concern is that stocks might be getting undervalued.

For reference, the P/E Ratio of the S&P 500 rose above 40 a few months before the 2001-2002 tech bubble corrected. Early in 2021, amidst a global health pandemic, the S&P 500’s P/E Ratio was also above 40.

But one can’t forget that the impairment of earnings during the pandemic is an important reason why the ratio might have trended so high. With earnings down, that meant the denominator of the P/E equation was lower—ultimately pushing the overall quotient higher.

In other words, the market may have allowed valuations to range well above their historical average because investors and traders expected corporate earnings to catch up, and slowly push that P/E back toward its historical mean.

As of early January 2022, recent data suggests that those expectations were well-founded. The P/E Ratio for the S&P 500 has indeed trended lower alongside a rebound in corporate earnings growth.

The S&P 500 P/E Ratio currently stands at roughly 29—well below the nosebleed levels observed in early 2021 (above 40). However, as illustrated in the chart below, the metric still remains well above its long-term average of 17.

S&P 500 P/E Ratio (January 2022)

Source: Multpl.com

As shown above, the S&P 500 P/E Ratio remains at the higher end of its historical range. That may indicate that valuations in the stock market could come under pressure at some point in 2022 if recent strength in corporate earnings falters.

The situation is especially tenuous in 2022 because the U.S. Federal Reserve has also indicated its intention to raise benchmark interest rates at some point this year. Rising interest rates are viewed as a headwind for earnings because when financing costs go up, profitability usually goes down.

To learn more about trading strategies geared toward corporate earnings, readers may want to review this previous episode of Tasty Bites on the tastytrade financial network. This recent episode of Options Jive also dovetails well with the topics covered in this post.

To follow everything moving the financial markets in 2022, readers can also tune into TASTYTRADE LIVE—weekdays from 7 a.m. to 4 p.m. CST—at their convenience.

Sage Anderson is a pseudonym. He’s an experienced trader of equity derivatives and has managed volatility-based portfolios as a former prop trading firm employee. He’s not an employee of Luckbox, tastytrade or any affiliated companies. Readers can direct questions about this blog or other trading-related subjects, to support@luckboxmagazine.com.