Earnings were supposed to save the US stock market, but they may well prove to be its downfall.
In the latest example of trouble, networking equipment giant Cisco Systems Inc. told investors late Wednesday that supply disruptions would erase sales growth in the current quarter, adding to negative outlook revisions this week from retailers Walmart Inc. and Target Corp. In all cases, stock bloodbaths ensued, the broader market came under attack and analysts started slashing their estimates for where share prices might end this year.
Some 162 companies in the S&P 500 Index received target price reductions Thursday compared with only 62 increases, according to Bloomberg data. The difference marked one of the sharpest swings in analyst sentiment in the 11 years of the series.
For months, market optimists have convinced themselves that earnings would buttress the stock market from 40-year-high inflation and surging interest rates. In their view, resilient consumer demand would keep sales strong, but few counted on persistent supply chain snarls that can lead to empty shelves one month and gluts the next. Now, analysts are revisiting those assumptions, but they’re likely just getting started in earnest, and they haven’t even begun to process the possibility of a full-blown recession.
If stock prices essentially distill to expected earnings and the multiple assigned to them — the price-earnings ratio, or P/E — then the first part of 2022 was mainly about the P, and the remainder will focus on the E.
Clearly, earnings expectations still have a lot of room to adjust downward. S&P 500 earnings estimates compiled by Bloomberg still imply 10.1% adjusted earnings growth in 2022 to around $227 a share. Even excluding energy stocks that are benefiting from the run-up in oil prices, the projections assume a 5.7% gain.
As DataTrek Research co-founder Nicholas Colas wrote Thursday, much of that expected EPS growth is backloaded into the remaining part of the year. Investors may be sensing the flimsiness of those projections, judging from the S&P 500’s 4% selloff Wednesday, the worst since June 2020, but analysts still aren’t there yet. “That story is falling apart,” Colas told me Thursday. “Every cycle downturn has those emblematic days where the market sort of gets the theme. And I think yesterday was one of those days.”
So how low will stocks actually go? Colas suggests considering “the old Wall Street ‘Rule of 20’”:
... which says inflation expectations plus the S&P PE ratio equals 20 over time. Current 10-year inflation expectations are 2.7 percent, making 17.3x notional “fair value.”
Coincidentally, that’s roughly the multiple at which the market is trading today. If you assume Colas’s rule-of-thumb multiple, and earnings decline 5% from their run rate in the past two quarters, that produces an S&P 500 value of 3,616, according to Colas’s calculations, compared with a close of 3900.79 on Thursday. Accordingly, an earnings drop of:
- 10% = 3,425
- 15% = 3,235
- 25% = 2,837
In a typical recession, earnings drop 25%, Colas said, but you don’t need to imagine a worst-case scenario to see how stocks could go lower from here. There are many other risks, of course, including another wave of the pandemic; Russia’s war in Ukraine; and the possibility that inflation will become so ingrained that it won’t even dissipate in an economic downturn — the nightmare stagflation scenario. What’s clear is that earnings are no longer a viable excuse to stay positive about stocks. Without that cushion, the market could be facing a long way down.
Bloomberg News provided this article. For more articles like this please visit
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