The current economic expansion is nearing its seventh anniversary, and most indicators point to a limited chance of a recession in the near future. However, another type of recession, an earnings recession, is underway. What exactly is an earnings recession, and what does it mean for markets and the economy?
What Is An Earnings Recession?
Though the National Bureau of Economic Research makes official calls on recession dates, a common generalization used by markets is that two consecutive quarters of negative economic growth indicates an economic recession. Similarly, two quarters of negative year-over-year earnings growth is generally interpreted as an earnings recession. Specific earnings and earnings growth rates vary depending on source (Thomson, FactSet, and Bloomberg, among others) due to different methods and interpretations of operating earnings; but all of these sources indicate we are currently in an earnings recession. For this analysis, we measure earnings growth in terms of a year-over-year comparison of trailing 12-month earnings.
Overall, S&P 500 company earnings saw their first year-over-year decline since 2009 in the third quarter of 2015, the second in the fourth quarter of 2015, and now a third, as the first quarter of 2016 is tracking to a decline of 4% based on our methodology. This constitutes an earnings recession as earnings have declined for more than two consecutive quarters; however, a closer look reveals that the earnings recession is not very broad.
Narrow In Scope
Energy has been the key driver of this earnings recession, with negative earnings growth starting in the fourth quarter of 2014, and most recently reporting trailing 12-month earnings down nearly 67% from a year ago. However, energy only makes up a little over 7% of the S&P 500 Index. Only two sectors, energy and materials, have officially met the criteria for an earnings recession; two others, financials and consumer staples, are showing single quarter declines. The remaining six sectors are still posting positive earnings growth.
The History Of Earnings Recessions
Earnings recessions are nothing new for markets, with the S&P 500 experiencing 12 since 1954. Nine earnings recessions happened within one year before or after economic recessions, leaving three that did not accompany a recession.
The average earnings recession since 1954 lasted a little over 6 quarters, and the maximum year-over-year earnings decrease averaged 17%, but the lengths and severities vary widely. The 1990 earnings recession lasted 11 quarters (almost 3 years), and the maximum earnings decline in the 2008 financial crisis came in at more than 35%. The effect that earnings recessions have on the market can also vary. Figure 2 shows each earnings recession, along with the length, maximum drawdown in earnings, and maximum drawdown in the S&P 500.
A key driver of the extent of a stock market pullback that is driven by an earnings recession is whether it is accompanied by an economic recession. When an economic recession happens within one year of an earnings recession (either before or after), the maximum decline (peak to trough) for the S&P 500 during the earnings recession has averaged nearly 30%. The two earnings recessions not accompanied by economic recessions witnessed a much lower 8% average maximum drawdown (not including today’s). However, it is also important to note that both of these earnings recessions experienced large pullbacks in the stock market either a year before or after. The 1967 earnings recession saw a max drawdown in the S&P 500 of 22% in the year prior, and the 1985 earnings recession saw an even steeper pullback of 33% in the following year, though approximately 20% of that drop happened in one day (October 19, 1987, better known as Black Monday).