The Earnings Recession Is Finally Here. Apparently, That Just Means Buy Stocks

A smattering of weekend posts across mainstream financial media highlights the disconnect between profit growth and record-high stock prices.

Or maybe “apparent” disconnect is better. We’ve been over this before.

Now that multiples are elevated following a year during which virtually all gains across global equities were attributable to valuation expansion, the narrative pretty much has to be that stock prices are anticipating an inflection in bottom-line growth.

It’s either that, or you’re clinging to the notion that multiples can expand still further – that investors will continue to pay more for a dollar of earnings, content to chase the market higher irrespective of the outlook for corporate profits. “I’ll buy it up here, because somebody will surely buy it from me way up there“.

If Q4 earnings season (which kicks off in earnest next week) develops as expected, the earnings recession that folks have been talking about since the fourth quarter of 2018 will be a reality. As things stand right now, consensus expects to learn that profits fell 1.6% in Q4 2019, the second straight quarter of contraction.

As you can see, the assumption going forward is that an inflection is imminent – that rising labor costs, tariff pressures and difficulty in passing along higher costs to consumers won’t crimp margins too much.

And who knows, that may turn out to be true. After all, there is some evidence to support the contention that while over the long-run, stock prices follow earnings growth, in the near-term, blockbuster returns like those seen in 2019 against a backdrop of lackluster earnings presages an inflection in profits (and vice versa).

Read more: Prophesying Profits

That, in turn, means that when you see nosebleed multiples like those that persist currently, you could just argue that stocks are anticipating an improvement in earnings.

(Never mind the fact that if that’s your argument, you will never suggest that it’s a good idea to exercise caution – if you’re inclined to say that huge gains are a buying opportunity because they foretell healthy profit growth, you’ll doubtlessly suggest that healthy profit growth, if it pans out, is also a reason to buy any concurrent dips. You’ll thus always be a buyer. Which is fine if your investment horizon is “forever”, but if you’re any kind of tactician, that kind of reasoning will probably make a you a bag-holder at some point, even if central banks make you “right” more often than not.)

The Nasdaq 100 is trading at a forward multiple of more than 22X. The S&P is cheaper at “just” 19 and 17, for 2020 and 2021, respectively, but is currently trading in excess of 20X 2019’s profits. The number of ways to suggest equities are overbought amid the ongoing melt-up is multiplying, especially for big-caps.

And yet, there’s always the old standby – the “relative attractiveness” argument or, more simply, the comparison to bonds. Goldman implores you to consider the wide gap between stocks’ earnings yield and benchmark bond yields, and SocGen notes that US equities remain undervalued versus Treasurys, something they note is “historically quite rare for this stage of the economic cycle”.

BofA, meanwhile, said Thursday that the S&P can keep on goin’ until it trades at a forward multiple of 20 or, at least until you start to see trouble in chips and financials, which “predicted” the bull’s brush with death in 2018.

It’s worth noting that although there are plenty of indicators which suggest the US economy is set to motor along in 2020, there’s not much in the way of evidence to support a case for blockbuster growth, which in turn raises questions about the viability of any assumed “hockey stick” inflection in earnings.

ISM continues to scream that something is wrong, but nobody is listening.

And yet, maybe we should – listen that is.

The following chart is labeled to suggest that an inflection may be in the offing, but the overarching point is that it may not be safe to write off ISM as a “barbarous relic” (so to speak) of that bygone era when US manufacturing actually mattered.

(SocGen)

Draw your own conclusions.