Trading Desk: The Earnings Recession Is Here

The gloom around the economy has finally hit Wall Street. Analysts have lowered their earnings target on the S&P 500 by close to 6 percentage points over the past month . . . enough to turn what previously looked like faint progress in the current quarter into a year-over-year decline.

Needless to say, that’s not great. Shareholders rarely want to own companies that are shrinking. We like expansion, growth, success. Too much deterioration across too long a timeline is a road to corporate extinction.

But as long as the contraction is transitory, we can bear it. Real investors know that even great companies need to brake once in a while . . . an isolated quarter or two is not the end of the world.

After all, we were looking at a similar earnings recession at the end of 2019, before the pandemic trashed all expectations. Stocks laughed it off on the way to record highs.

Believe it or not, I think the global economy is in slightly better shape now than it was three years ago. And if I’m right, shareholders willing to shake off the gloom can actually buy great companies at a discount price here.

Wind Back The Clock

After wild swings in monetary policy, a lot of investors have forgotten the pre-COVID environment that initially supported the bull market at the time. The mood back then was so confident that it feels almost naive in today’s climate of exhaustion.

But the global economy was showing signs of hitting a wall. Revenue growth on the S&P 500 had slowed to a 2.6% crawl by the end of 2019. With profit margins narrowing in the trade war’s wake, only 11.5% of that revenue moved to the bottom line.

As a result, we were all steeled for a 1-2% earnings decline. We told ourselves that the contraction would be brief . . . all the models showed that growth would recover in the new year and stocks would once again get the numbers the bulls wanted.

Of course COVID took over the narrative shortly after the 4Q19 season was over, so the models became irrelevant fast. However, at the time, the contraction never actually happened. The S&P 500 as a whole reached deep into the balance sheets and found 0.9 percentage point of progress.

If not for the pandemic, that would have been as bad as it got: not an earnings recession but only a slowdown, practically a seasonal pause in a growth curve that otherwise could have stretched forever. The rally might’ve continued right along with the fundamentals. After all, investors were feeling good and the economy gave us good reason to keep cheering.

I’m not saying the market will dodge a negative growth number this quarter. Between inflation and the Fed’s fight against it, there’s just not a lot of shelter.

But compare that lack of shelter to what we faced three years ago. Back then, we were bracing for revenue to slow to a 2.6% crawl. Even “hot” sectors like technology were only moving at a glacial 3-4% expansion rate, only a little faster than the economy as a whole.

Any quarter where healthcare, telecom and utilities are the big growth spots is probably a bad quarter for investors. Here we are now, looking for 4.2% revenue growth across the S&P 500 . . . not a great number, but better than what kept the bulls running in 2019.

Tech is once again a weak link. Any earnings recession is definitely a factor of Amazon (AMZN), Meta (META) and their peers.

Now, however, the hot spots are all about energy, manufacturers and Tesla. Banks, real estate companies and other consumer stocks are still moving forward in the background. Factor out technology and revenue looks even better.

For that matter, factor out technology and there’s no earnings recession in the targets at all. Apple (AAPL), Intel (INTC) and Microsoft (MSFT) are becoming a drag. They’re collectively big enough that that drag casts a shadow on the entire market.

You know my motto. Nobody’s forcing you to own a big stock just because it’s big. Even big stocks can be bad investments . . . they did well in the past but the past is dead. We have to look toward the future.

What Kind Of Recession?

The market as a whole isn’t cheap right now. Back at the end of 2019, the S&P 500 commanded a 16.7X multiple, which felt a little precarious at the time.

That was only justified if you assumed that the end-of-year earnings contraction would be brief.¬†Here at 17.1X, stocks today are already pricing in a similar “bump in the road” scenario.

Despite all the talk, big money isn’t looking toward a deep multi-year recession along 2008-9 lines. They’re betting that the current quarter is as bad as it gets.

If they’re right, we’re at most a few months from seeing growth recover to the point where the narrative becomes too tempting to ignore. Nobody wants to miss that moment.

And maybe they’re wrong. Maybe blowback from some unexpected shock will rip through the earnings models like COVID did three years ago.

What happened three years ago? The Fed stepped up like never before. A repeat of 2008 terrifies them. They’re not going to let another Lehman Brothers die on their watch if they can help it.

We might see a few hedge funds implode as margin calls expose them to forced asset sales. It happens. Traders who deal themselves a bad hand need to fold and leave the market.

There will always be a drumbeat of disaster. You probably don’t remember the way names like Long-Term Capital Management and Amaranth crushed the market mood for a generation . . . because they didn’t.

Regulators stepped in to cushion the impact. The bulls stumbled, paused and got back to work. Rallies rolled on.