Livin’ on a Prayer
The next stop on the market news train is Q1 earnings season, which begins in earnest next week, and the industry group kicking it off is…wait for it…banks. All eyes and ears will undoubtedly be on regional bank earnings and guidance from big bank CEOs, but the rest of the industry groups could be just as interesting to watch.
Aside from the fact that I am a Bon Jovi fan, this earnings season does feel a bit like we’re livin’ on a prayer that profit margins don’t contract too much. The story has been that profit margins are high enough to withstand a little pullback in revenue growth and increased costs from inflation — largely because consumers have thus far absorbed price increases.
A potential hole in that story is that consumers can change their minds on a dime, and they’ll only absorb price increases until they very abruptly won’t. The problem with that timing is that companies cannot react as quickly as consumers can change their behavior — which may result in too much inventory and the need to reduce prices in order to unload it later on. Lower prices mean lower revenue. Lower revenue without equally lower costs means lower earnings.
We’re Halfway There
As of now, Q1 earnings growth on the S&P 500 is expected to come in at roughly -6% y/y. After Q4’s -3.5% growth, we were halfway to what’s called an “earnings recession” (two consecutive quarters of negative growth), and if Q1 posts a negative result we’ll have fully checked the box. It’s worth noting that current estimates also call for -4% growth in Q2 2023 earnings, so the contraction is expected to continue.
One of the important data sets to watch is trailing earnings on the S&P, where we can track the cycle peak in earnings per share (EPS), and monitor each earnings season for how much of a slowdown is occuring. Additionally, it’s useful to keep in mind how much the average earnings contraction is during a recessionary period, which we’ve calculated as -23% from peak to trough.
Still too early to know how steep the decline in earnings could be, but it appears that the peak was reached in Q3 2022 at $218/share. If, and only if, EPS declines the average percentage, the chart above shows what that level would look like.
Although I think the wider profit margins and heavy cost cutting that has already occurred in the tech sector could prevent the drop in earnings from being that dramatic, I do think current estimates for 2023 earnings are still a bit too high. Especially given the economic environment and lack of movement in estimates after the recent banking stress.
We’ve Gotta Hold on, Ready or Not
Generally, the recipe for a true contraction phase in the business cycle includes a bear market (-20% or more peak to trough), an earnings recession, and an economic recession (two consecutive quarters of negative GDP growth). Typically they occur in that order, too.
It’s true that we already saw a bear market in the S&P 500 and the Nasdaq in 2022, but that doesn’t mean the pullbacks are over. In fact, I still believe we could see a pullback that results in a peak-to-trough decline in the S&P of 30% or more (note: the peak I’m referring to is 4,796 on January 3, 2022).
Since we’ll have the verdict on a possible earnings recession in less two months, that would tell me we’re ripe for a market pullback to begin sooner rather than later. Time will tell, but this earnings season is a crucial part of the equation that is about to start unfolding.
After many weeks of caution and finding opportunities in safe havens such as short-term Treasuries, gold, money market funds, and defensive equity sectors, I’m still holding that line, but I do feel like the movements we’ve been preparing for are drawing nearer.
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