Wall Street analysts have trimmed their overly optimistic earnings estimates slightly in recent months, but they’re still nowhere close to acknowledging the threat of a recession. That leaves the market especially vulnerable if other companies follow FedEx Corp.’s move to withdraw its profit guidance by lowering their own outlooks.
FedEx’s decision late Thursday sent its shares tumbling the most since 1980 and came amid a growing disconnect between the macroeconomic outlook and analysts’ earnings projections, which are driven to a large degree by the hints that companies provide about their futures.
The median economist surveyed by Bloomberg now gives even odds of the US experiencing a recession in the next 12 months, up from about a 33% probability at mid-year. Economists are concerned that the Federal Reserve’s efforts to rein in the worst bout of inflation in 40 years will ultimately come at the expense of the job market and resilient consumption trends. The hard data suggest that the economy hasn’t buckled yet, but history suggests that it will eventually, and there’s little chance that stocks would be immune.
Since 1960, the average peak-to-trough earnings drop in a recession is about 31%, based on Yale University professor Robert Shiller’s data. Yet sell-side equity analysts aren’t even close to incorporating such a drop. In fact, estimates for both 2022 and 2023 still imply that rolling 12-month earnings will maintain their steady upward slope, implying something close to a best-case scenario.
It’s not just the analysts who are optimistic, though; markets appear to be buying this optimism to a large extent, even after accounting for last week’s 4.8% slump in the S&P 500 Index. The S&P 500 earnings yield — the ratio of expected EPS to price, or the inverse of the P/E ratio — has continued to track Treasury yields throughout the year, indicating that it’s the latter that’s truly driving the market.
At some point, the emphasis will necessarily shift to earnings, but that transition still hasn’t happened. If markets were actively questioning the earnings outlook or generally anticipating more risk in equities, that would be reflected in a wider earnings yield-Treasury spread. On the few occasions when the earnings yield has broken stride with 10-year Treasury yields, it’s often been because traders applied a more bullish bias to equities.
So why do investors appear content to stay so upbeat on earnings despite all the apparent headwinds? First, market participants may have reason to doubt that the 50% odds of a recession are correct. The resiliency of earnings and macroeconomic data so far this year have bolstered the belief that this rate-increase cycle will be unlike most others and that the Fed will deliver the elusive “soft landing.” The unemployment rate remains close to its all-time lows; household leverage ratios remain very low; and retail sales are mostly humming along, at least nominally. Many traders may find it hard to square economists’ pessimism with the facts on the ground. It may take a clear turn in the hard data to change their minds. Alternatively, a series of companies abandoning or revising down their earnings forecasts might do the trick.
Second, not all recessions are catastrophic. Although an average recession zaps 31% off EPS, the mean is weighed down by the dot-com bust and the financial crisis, as my Bloomberg Intelligence colleagues Gina Martin Adams and Gillian Wolff noted recently in their research. Given the many financial advantages households have to withstand a downturn, traders may believe that any recession and subsequent earnings trough would be shallower than other recent ones — and perhaps more like the downturns in the 1960s, 1970s and 1980s. Of course, investors should be careful what they wish for: The ’70s and ’80s may have had shallower recessions, but the slumps were also more frequent.
Even if you split the difference between the mildly optimistic and the mildly pessimistic — 50% odds of the Wall Street status quo with ho-hum earnings growth, 50% odds of a mild recession — a probability-weighted approach would have traders betting on single-digit earnings declines in the next 12 months, but the market isn’t quite there yet. Historically, recessions have also coincided with lower forward P/E multiples from the current 16.5 times. But even if you’re somewhat generous with the multiple, it’s clear that market pricing still sits on the optimistic side of the earnings fence. As the following table shows, there are plenty of paths for the S&P 500 to break through the June low of 3,667, and probably fewer paths higher.
The FedEx news had the market on edge heading into the next Fed monetary policy decision on Wednesday, in which policy makers are expected to raise the upper bound of the fed funds rate by 75 basis points to 3.25%. For all the strength in the economy, the famous “long and variable lags” of monetary policy are likely to bite at some point soon, and the equity market looks ill prepared for what’s coming. None of that means that the US is heading for some kind of 2008-style earnings calamity, but you don’t have to believe that to acknowledge that the market looks overly sanguine. The FedEx development may well be the first in a series of catalysts that help traders realize that.
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