The median economist (1) interviewed by Bloomberg now also provides the odds that the US will experience a recession in the next 12 months, compared to a roughly 33% probability in mid-year. Economists fear that the Federal Reserve’s efforts to curb the worst inflation wave of the past 40 years will end at the expense of the labor market and resilient consumer trends. Hard data suggests the economy has not yet collapsed, but history suggests it will eventually, and there is little chance that stocks are immune.
Since 1960, the average drop in earnings from peak to low in a recession has been about 31%, according to data from Yale University professor Robert Shiller. Yet sell-side stock analysts aren’t even close to incorporating such a decline. Indeed, estimates for both 2022 and 2023 still imply that 12-month rolling earnings will keep their steady upward slope, implying something similar to the best-case scenario.
However, it is not just analysts who are optimistic; markets seem to accept 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 ‘inverse of the P / E ratio, it has continued to track Treasury yields throughout the year, indicating that Treasury is truly leading the market.
At some point, the emphasis will necessarily shift to earnings, but that transition hasn’t happened yet. If markets actively questioned earnings outlook or generally anticipated greater risk to equities, this would be reflected in a larger spread between earnings yield and Treasury. On the few occasions that earnings yields have broken pace with 10-year Treasury yields, it has often been because traders have applied a more bullish bias to equities.
So why do investors seem happy to remain so optimistic about earnings despite all the apparent headwinds? First, market participants may have reason to doubt that the 50% odds of a recession are correct. Earnings resilience and macro data so far this year have reinforced the belief that this rate hike cycle will be different from most others and that the Fed will deliver the elusive “soft landing”. The unemployment rate remains close to historic lows; household leverage ratios remain very low; and retail sales are mostly buzzing, at least nominally. Many traders may find it difficult to square economists’ pessimism with the facts on the ground. It may take a clear turn in the hard data to change your mind. Alternatively, a number of companies abandoning or lowering their earnings forecasts could do the trick.
Second, not all recessions are catastrophic. While an average recession reduces EPS by 31%, the average is weighed down by the dot-com crash and the financial crisis, as my Bloomberg Intelligence colleagues Gina Martin Adams and Gillian Wolff noted recently in their research. Given the many financial benefits households have for weathering a recession, traders may feel that any recession and subsequent earnings depression would be less than recent ones – and perhaps more like the downturns of the 1960s, 1970s, and ’70s. 80. Of course, investors should be careful what they want – the 1970s and 1980s may have had less deep recessions, but slumps have also been more frequent.
Even if you split the difference between the moderately optimistic and the moderately pessimistic – 50% chance of the Wall Street status quo with staggering earnings growth, 50% chance of a mild recession – a probability-weighted approach would do yes. that traders are betting on – Earnings in figures decline over the next 12 months, but the market is not there yet. Historically, recessions have also coincided with forward P / E multiples lower than the current 16.5 times. But even if you are quite generous with the multiple, it is clear that market prices are still on the optimistic side of the earnings barrier. As the table below shows, there are plenty of paths for the S&P 500 to break through the June low of 3,667, and likely fewer paths further up.
The FedEx news pushed the market to the brink of the Fed’s next monetary policy decision on Wednesday, where policymakers are expected to raise the upper bound on the federal funds rate by 75 basis points to 3.25%. Despite all the strength of the economy, the famous “long and variable lags” of monetary policy are likely to take hold at some point and the stock market seems unprepared for what is to come. None of this means that the US is heading towards some kind of 2008-style earnings calamity, but you don’t have to believe it to recognize that the market is looking overly optimistic. FedEx development could be the first in a series of catalysts that help traders understand this.
More from other writers at Bloomberg Opinion:
• Wall Street denies the “real” economy: Gary Shilling
• Your Guide to the Permanent Pandemic Economy: Allison Schrager
• The 2023 rate shock may be in its normalcy: Daniel Moss
(1) Economists as a group have little experience predicting recessions, but that’s usually because they are too conservative. They very rarely predict those that do not occur, as an IMF working paper found.
This column does not necessarily reflect the opinion of the editors or Bloomberg LP and its owners.
Jonathan Levin has worked as a Bloomberg journalist in Latin America and the United States, covering finance, markets and mergers and acquisitions. Most recently, he served as the head of the company’s Miami office. He is a CFA charterholder.
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