Keep going for as long as 70 years, and investments are generally able to come good. As with the Queen herself, investors would have found that discipline, patience and a certain passivity would have paid off.
Profits of Doom
What have we got to be afraid of? A myriad of factors pose threats to U.S. equities, from sky-high inflation to hawkish central banks and looming geopolitical risks. But corporate earnings—which are what you buy when you buy a share—could ultimately be far more important. They boosted the stock market over the summer when results held up better than feared for the second quarter. But profit forecasts for the third quarter now approaching its end are dipping sharply. It’s usual for this to happen as companies try to talk down expectations but, as this chart from Jonathan Golub of Credit Suisse Group SA shows, the dip in the last few weeks has been far worse than the average:
S&P 500 earnings estimates for 2023 have also been falling in recent weeks, according to a Sept. 2 note published by Bloomberg Intelligence’s Wendy Soong. For this year, she expects S&P 500 earnings-per-share to be at $226.50 down 0.7% from peak, while S&P 500 EPS for next year has taken a bigger hit to stand now at $240.80, down 3.3% from the midsummer peak:
The picture looks worse if the earnings of energy companies (massively boosted by the high oil price this year) are excluded. Andrew Lapthorne, chief quantitative strategist at Societe Generale SA, juxtaposes the course of earnings expectations with and without energy in these charts—note how different the scales on the axes are:
Earnings are related to the economic cycle, but not tightly, and expectations for next year are intertwined with macroeconomic concerns about the risk of a recession. Historically, the S&P 500 has experienced an earnings recession (two consecutive quarters of year-on-year earnings declines) in each of the periods after a three-month/10-year yield curve inversion, according to Bel Air Investment Advisors strategists including Carl Ludwigson, Richard Ratner and Craig Brothers. This is also regarded as the clearest bond market indicator that a recession is coming, and that curve did invert for a matter of hours last month.
However, earnings expectations are holding up a little too well to be consistent with an imminent recession. To quote Golub:
Although revisions are negative, projected EPS growth rates remain positive for the remainder of 2022-23. While 3Q growth has fallen to 4.7%, EPS should expand 9-10%, assuming similar beats as experienced in 2Q. Historically, earnings hold up best when inflation is elevated. Many investors are interpreting the recent decline in estimates as a harbinger to recession. Our work shows that in high inflationary periods (1973, 1980, 1981) earnings peak just 2 months prior to a recession’s onset. With EPS growth projections still positive, revisions would have to fall much more to signal an economic contraction.
Put differently, the revisions of the last few weeks are a “far cry from the punch in the gut” that many were anticipating, Liz Young, head of investment strategy at SoFi, said. With the benchmark index falling as much as 24% peak-to-trough, worse had been priced in. And beyond that, record high profit margins provide a cushion. She said that it was the larger downward revisions seen ahead of prior recessionary periods that concern her, especially when paired with a bear market—and this implies that the falling expectations for 2023 are more significant:
During recessions, the average peak-to-trough decline in trailing 12-month earnings is roughly 30%. Not every recession sees that steep of a drop. Some are much more shallow (-4.6% in 1980) and some are much more severe (-91.9% from 2007-2009). There is no magic level that says ‘this is recessionary,’ but earnings would need to come down markedly from here in order to become a recession signal, in my view. In particular, if 2023 EPS are revised down by 10-15% or more, it would be difficult for us to avert recession.