$11 'TIS THE (EARNINGS) SEASON
Equity valuations always reach their lows before earnings trough
Equity valuations always reach lows before earnings trough
Largest earnings recessions were highly amplified by concentrated sector weakness—hard to imagine a large earnings recession without substantial drag from the largest index constituents
In a recessionary environment, a “mild“ 14% decline in EPS would be consistent with the four recessions dating back to the inflationary environment of the 1970-80 period
Come to Europe, they said. It will be cheap, they said.
What most fail to mention—and what you do not get to see in those perfectly edited pictures in the Balearics, Sardinia or Greece—is that the last few summers in southern Europe have felt like that level in Super Mario where the sun is trying to kill you.
Stay hydrated, folks!
Summer Doldrums, Volatility Down
Volatility has receded across equities, bonds and commodities (to some extent), triggering a continuation to the “timid” rally described in previous notes. Liquidity is softly improving, which translates directly into volatility leaking lower1.
Mechanical flows are driving the tape and I’ve taken the opportunity to substitute some of the outright shorts I had with put options. This allows me to trim my position and add convexity in case of a resolute move lower. I can find powerful arguments for a continuation of the rally, which makes me wary.
I have also used this last rally to ring the register on some of the uranium ("#SPUT) I tactically accumulated at the trough of the recent commodity scare.
I’ll use this chance to remind you that I tend to document my moves on Twitter. If you don’t follow me yet, feel free to do so (@GoingJGalt) for additional updates and resources / information.
Slowing economic activity in the US appears to be weighing on housing starts, finally. Housing slumped to the lowest level in 9 months, posting negative growth. As highlighted in my last piece touching on US housing, these figures are relevant:
Keep an eye on housing starts alongside the more popular metrics (home sales and prices), as recessions historically have always come with declines in starts.
Read more: $10 IF IT BLEEDS, WE CAN KILL IT
Fed chatterboxes (Waller and Bullard) offered support for yet another 75bps hike and markets are in agreement (70-85% probabilities lately). So is Fed Whisperer Nick Timiraos, which cements the chances of a triple hike in next week’s FOMC meeting.
Across the Atlantic the EUR (briefly) attained parity against the dollar and millions of Americans landed in Europe, partially making up for Russian tourism.
Ibiza likes this 👍
Yesterday, the ECB hiked rates (50bps) for the first time since 2011. With BTP-Bund spreads back at cycle highs, Lagarde’s announcement included details on the vaunted anti-fragmentation tool (now officially “Transmission Protection Instrument”, TPI).
These were in line with those anticipated in a previous note ($9 MAKE 75BPS HIKES GREAT AGAIN), albeit questions arose on the “conditionality” of the program (i.e., dependence on taking [fiscal] actions to unlock the asset purchases), renewing pressure on the EUR. European investors are left asking what such a mechanism is good for if the main recipients—peripheral countries—are out of its scope.
Russian gas flows intermittently, further cornering Europe’s industrial economies. Brussels is toying with a 15% gas cut for all EU members and Spain, Greece and Portugal are having none of it. “Unlike other countries, we Spaniards have not lived beyond our means from an energy point of view”, declared Spain’s energy minister in clear reference to remarks coming from the bastions of fiscal rectitude in “core” Europe during the Eurozone crisis.
Italy looks for a new new Prime Minister—after Draghi’s resignation—none of the candidates seem to like the EU.
In light of the current market respite and to celebrate earnings season—71% of S&P 500 by market capitalization reports results by July 29, banks having already disappointed last week—I thought I’d use today’s note to discuss earnings recessions.
Breaking down the historical interplay between the components underpinning valuations (P/E multiple)—equity prices (P) and earnings (E)—sheds a bit of light on potential recessionary environments going forward. Finally, I will highlight the importance of understanding sector contributions.
“The problem with (current) lower P/E ratios is that while the ‘P’ has moved, the ‘E’ is on thin ice, and the cracks are starting to show.” — Albert Edwards, Société Générale
Historical Data on Earnings Recessions
Fundamentally bearish investors seem to be coalescing around the thesis that the next leg down will follow lackluster earnings reports, as central banks combat inflation at the expense of growing economic activity.
There’s no lack of fundamental headwinds to support the earnings downgrade. Revenue expansion is starting to be throttled by decelerating demand, while input cost pressures remain stubbornly high and debt service rises due to central bank tightening of financial conditions. Certainly, not a combination of factors conducive to corporate profitability.
Earnings revisions have started to roll in and guidance of company management teams is expected to consolidate the earnings’ slowdown.
After consolidating datasets from multiple parties2 the conclusion is clear: equity valuations have always reached their lows before earnings troughed.
The table below shows S&P 500 data for every crisis since 1970. Note that the date of the crisis is the widely accepted reference year, not necessarily the date earnings bottomed. The cycle repeats every single cycle:
Equity valuations (LTM P/E) overshoot to the downside and reach their lowest point (11.4x median, ranging from 6.5x in 1980 to 19.7x in 2001).
Only after several months (9 months median, range 6-12 months) do earnings find the bottom (peak to trough -18% median, range -5% in 1980 to -43% in 2008).
As we approach the bottom in earnings, valuations anticipate it and start rebounding before reaching that point, so when the low is in valuations are already higher (18.0x median, ranging from 9.4x in 1980 to 28x in 2001).
Taking 2020 as an example, we saw the S&P 500 bottom in March 2020 (13.8x LTM P/E), well before the earnings lows were in (December 2020, 9 months later). Over that period, the market anticipated that earnings would bottom, so the recovery started and by the time the actual earnings low was in (-18%) for the cycle, equity valuations had jumped to 28.0x foreseeing growth.
Other findings include:
Nominal Sales growth is incredibly resilient (median +2%). Sales actually grow quite often during recessions—four of the past eight—including three in the previous inflationary period of the 1970s and 1980s.
Profit margins always decline (-115bps median, -51bps in 1980 to -177bps in 2001). Sales and profit margins show correlation through operating leverage.
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Extrapolating EPS for Recession
Now, with this bit of information at hand, let’s play around and extrapolate our own Earnings Per Share (EPS) trough for a potential recession.
First, Earnings Per Share (EPS) in Q1 for the S&P 500 was ~$216 (Last-Twelve-Months, LTM), while consensus expects ~$230 for 2022 and ~$250 for 2023.
As of Wednesday, reported earnings were overshooting consensus (72% were above estimates, trailing the Last 2Y average of 80%). Considering Q2 earnings are already in the books and in line with consensus, let’s use Q2 2022 EPS at $220 as a starting point.
Additional factors to account for in our EPS decline estimation:
An argument can be made for nominal S&P 500 sales to remain flat considering precedents, particularly in high-inflation environments.
Profit margin expansion over the past last two years has been one of the main drivers of the S&P 500 index3. Post-pandemic profitability seems resilient in the face of new COVID variants leading to lockdowns, rising input costs, and elevated supply chain disruptions.
The forecasted $250 EPS for 2023 seem excessively optimistic and mainly driven by record-high consensus profit margins at 12.7%. I’m inclined to believe that profitability will fall over the next year—even absent a recession—and analysts will be forced to revise their forecasts lower, as they generally do. Every year, EBIT margins are supposed to increase by 50-100bps before they get ultimately revised lower. Roughly in line with today’s consensus estimates for 2023.
Debt service follows interest rates and its rise entails a drag on profitability, despite the predominance of longer term, fixed-rate debt across the S&P 500 complex. Estimates indicate that a 100bps rise in borrowing costs lowers profit margins by roughly 40bp and earnings by about -3%.
Finally, a few lines to highlight the importance of understanding sector contributions in earnings recessions for your own risk management exercises. This is not only relevant for individual equities investors, but also for index investors judging by the size and profitability of the largest constituents in today’s index.
The largest earnings declines were highly amplified by concentrated sector weakness, as it was the case in 1990 due to Autos (only -10% EPS ex. Autos), in 2001 with Info Tech (-9% ex. Tech) or the most recent example in 2008 when Financials ultimately sunk index EPS to a record decline (-19% ex. Financials)4.
It’s hard to say what the weakest link could be in the current environment, yet considering size and profitability let’s hope it’s not Information Technology (~22% of 2021 EPS).
With all this in mind—if a recession actually materializes—I favor a relatively mild 14% decline in EPS consistent with the four recessions found in the inflationary environment of the 1970-80 period. More modern recessions (since 1990) have seen median declines of 21%, driven by the GFC outlier. It’s difficult to envision such magnitudes without substantial drag from the largest constituents5.
You may have spotted the big if in the paragraph above. History shows that for EPS to turn negative we need sub-1% US real economic growth. In order to get negative EPS we likely need an actual deceleration in economic activity, which we are currently not seeing on yearly GDP, despite the high likelihood of two negative quarterly prints.
A recession is not a foregone conclusion, despite some of us favoring this outcome!
I’d like to end with a wild thought that came to me while writing this piece. Turns out these notes do help with my process! Sufficiently bearish company earnings guidance could potentially create some cracks in the Fed’s hawkish stance, forcing a mild pivot that would catapult markets into the next leg of the rally.
While Q2 earnings season will likely beat estimates, I’ll be tracking company guidance for future earnings.
A final housekeeping note to cap things off. I’m proud to announce that Going John Galt was recently added to the excellent selection of financial content offered by Harkster, which aggregates the best content into a free newsletter every morning. This is not paid advertising (or advertising of any kind)—I just think it’s a useful resource that I do use every day and I’m proud my newsletter made it there.
Thanks for reading,
30-day realized $SPX volatility trades above the VIX—a phenomenon coincident with fading sell-offs which mechanically contributes to rallies.
I’ve never thought of being a political analyst, but this is what it must feel like to consolidate facts from biased news providers. Different datasets yield slightly different numbers, yet its interpretation was remarkably similar. I’ve tried to unify the figures across the sets to the best of my abilities and appreciate the input from all parties (Deutsche Bank, Goldman Sachs, Mr. Blonde and Koyfin).
According to Goldman Sachs, “the trailing 4-quarter S&P 500 net profit margin reached a record high of 11.3% in 2018 before slipping by 60 bp in 2019 and another 100 bp in 2020, but quickly rebounded and sprang to new record highs by mid-2021.”
Additional information on peak to trough declines in LTM earnings by sector.
Having spent way more hours in front of an excel spreadsheet than I’d like to admit, I must confess that I’m not terribly fond of most multivariable calculations. However and just for the sake of completing the exercise (and not necessarily a prediction), applying that 14% decline on our $220 Q2 EPS and using the LTM P/E of the 2020 lows (13.8x) we get to ~2,610 on the S&P 500. Note that at this rate of EPS expansion, every quarter sans recession substantially increases this estimate. By end of the year, that same figure would be ~2,630.