Trading Desk: Earnings Recession Is Already Priced In

Forget the way the energy sector is holding the economy as a whole together right now or the way earnings forecasts elsewhere in the market have deteriorated as the Fed engineers its slowdown. Even though the outlook is cloudy, stocks are priced for a whole lot worse than perfection.

And that’s a good thing. I get uneasy when the market gets too complacent in assuming best-case scenarios, but lately the opposite of that logic has been running Wall Street.

Yes, the fundamentals look like they’re stalling even as I write this. Earnings growth forecasts for the S&P 500 have dropped to a lowly 3.7% from a healthy 9.8% over the past two months.

It doesn’t take a lot of big misses to take the number all the way to zero . . . in which case Corporate America will be flashing a complete stop, with no appreciable forward motion since last summer.

Strip out energy stocks and Wall Street is already looking toward a 2.7% earnings decline when the quarterly reports start circulating in mid-October. That’s far from a best-case scenario, but as yet it’s a long way from a real earnings crash.

A lot of investors are still a little traumatized by the 2007-9 crash, when earnings on the S&P 500 fell hard for eight quarters in a row. As long as consensus is anywhere near reality, we’ll avoid repeating that experience this time around.

In that scenario, the earnings environment looks more like the soft decline we all survived in early 1999 . . . or late 2012 and early 2013 . . . or much of 2015 through 2016. Not a lot of people remember those brief earnings recessions because the market kept rolling with the punches and ultimately kept reaching for records.

Wall Street can handle a brief earnings slowdown or even a temporary retreat. Admittedly, stocks go in circles in the meantime, but you’ve got to pick your spots.

The long arc still points up. If that’s not fast enough for you, you just need to abandon the “buy and hold forever” mindset and start trading the cycle. Buy the dips. Sell the peaks. Repeat.

For now, however, stocks don’t look like they’re priced for utopia. Goldilocks has left the building, taking outrageous assumptions and valuations with her.

The S&P 500 isn’t trading at a crazy 22-24X ambitious future earnings any more. Instead, we’re faced with a more modest 16.8X consensus . . . far from expensive, even a little on the “cheap” side of average over the past decade.

Think about that decade. When it started, the market was still recovering from a serious shock and economic growth was sluggish at best. Close to the end, the Fed’s free money had inflated stock prices beyond historical limits.

But average the stall and the sizzle together and you’ve got something like “normal.” On that scale, the market is still 1-2% cheap.

This is not necessarily a buying opportunity for the market as a whole. People like Warren Buffett who live for deep value have already bought the dip and are waiting for a bigger decline before they put a lot more money to work.

But this is a long way from a sell signal. There’s no bubble for the market as a whole. Individual sectors are in better or worse shape depending on how their key constituents are doing relative to their fundamentals, but the S&P 500 itself seems fairly valued.

There’s no reason not to hold onto the market as a whole and wait for better times ahead. Supposedly growth starts accelerating again in Q4, which means this is as sluggish as the current cycle gets.

In that event, stocks will justify a premium again soon. Enthusiasm will build. The “hold” signal turns into something like a buy signal.

And in the meantime, you know we’ll rotate away from weakness back to relative strength. Energy is the only game in town right now on a sector level, but the industrials, real estate and even Amazon (AMZN) are coming back fast.

After Q4, energy becomes a year-over-year drag. That’s just how the market cycle goes. Keep rotating. Stay focused and responsive.