We are still in the longest bull market on record, yet the entire trading community seems convinced the bull market is about to roll over.
If analyst estimates are trustworthy, we are on the verge of an earnings recession, that is, two consecutive quarters where earnings growth goes negative compared to the same period the year before.
First-quarter earnings are expected to decline by 0.7 percent, according to Refinitiv, and second quarter earnings are expected to be up a measly 3.4 percent and seem vulnerable to further downward revisions.
As earnings recessions go, this one so far is pretty modest: It looks more like flat earnings growth after a torrential two-year run.
Regardless, last year’s 6.2 percent decline in the S&P 500 is being hailed as proof that the market has sniffed out an imminent drop in earnings. This news is being greeted with the usual round of hand-wringing from analysts and strategists, many of whom are predicting little if any upward movement in stocks this year. Especially after a 10 percent snap back in the market so far this year.
But does a modest decline in markets invariably mean earnings are going to plummet? It does not.
Let’s be clear, it’s not good news. The last time this happened, in 2015 and 2016, the S&P was indeed down for 2015, though by only a modest 0.7 percent.
After earnings growth north of 20 percent in 2018, what’s behind the slowdown?
First, moderating economic growth, both in the U.S. but particularly abroad. In the S&P 500, roughly 40 percent of profits are earned outside the United States, so when we see no growth in Europe, and a slowdown in Asia fueled by weaker growth in China, that is clearly an influence on U.S. multinationals.
Second, higher costs from raw materials (steel, plastics) to labor are hurting many companies and impacting profit margins.
Finally, there are also sector-specific issues. The decline in oil prices (since reversed) at the end of last year caused estimates of oil profits to plunge for 2019, and semiconductors are facing intense competition and oversupply.
But none of this necessarily means the market is in for a protracted bout of price declines. It’s useful to remember the two developments that historically have killed bull markets: sharp and sudden price hikes by the Federal Reserve and a recession.
The Fed, for the moment, seems out of the rate-hike game, so that is not a major factor.
That leaves a recession, the classic killer of bull markets. And that is where the fault lines lie. If you believe a recession —later this year or in 2020 — is imminent and unavoidable then earnings growth will indeed likely go deeply negative (double-digit declines) for several quarters and markets will likely see double-digit price declines from current levels.
But if a recession is avoidable, it’s quite likely the current flat earnings environment will not amount to much in the long term.
One final point: stock market declines do not invariably mean earnings are falling apart. A recent study by Ben Carlson on the blog “A Wealth of Common Sense” studied the S&P 500 in the 87 years from 1930 to 2017. He found earnings were negative in 30 of those years (34 percent). If the stock market was a perfect forward indicator and the primary mover was earnings, you would expect stocks to be down in the prior year in those 30 years. Yet Carlson found that stocks were down in just 12 of those 30 years prior to an earnings decline. “So roughly 40 percent of the time stocks may have been signaling a coming problem with earnings,” Carlson concluded.
Carlson noted that many factors, including recessions and high interest rates, were a factor in the earnings decline, but the point is a decline in stocks did not invariably signal an earnings recession.
The opposite is also true: flat or modestly negative earnings growth does not invariably predict a decline in stock prices.
This was the conclusion of Mark Haefele of UBS, who in a recent note to clients concluded that “[W]hile an ‘earnings recession’ may be a catchy headline, investors need to make a distinction between an earnings pause (which is a fairly benign outcome for investors) and an earnings plunge driven by economic recession where profits usually fall by 20 percent. Based on the preponderance of economic and corporate profit evidence, a temporary pause seems much more likely than a plunge.”