Shattered Dreams (Wile E. Coyote)

A couple of days ago, in “Prayers And Fundamentals“, I updated a chart I call “shattered dreams”.

It’s often lost on market participants that corporate America was already in an earnings recession before the pandemic catalyzed the biggest slump in profit growth since the financial crisis.

If you think the equity market is a reasonably efficient mechanism and that stock prices reflect trends in earnings growth (i.e., if you accept two of the key assumptions behind the view that the stock market is a worthwhile construct), then it makes sense that 2018 was a relatively rough year for equities and that 2019 was much better.

Of course, we all know the proximate cause(s) of 2018’s rough ride for risk assets was/were over-tightening by the Fed/the trade war. Similarly, we know that 2019 was a year defined by rate cuts and a pivot back to monetary accommodation, which in turn boosted asset prices.

But you might also argue that 2018’s swoon for stocks was just the equity market realizing that the blockbuster EPS growth catalyzed by the tax cuts was as good as things were likely to get. Profit growth in 2019 was destined to be comparatively lackluster, hence lower equity prices in 2018.

According to a 2019 study by Ned Davis, when corporate profits rise 20% or more in a given year, US equities rise just 2.4%, while in years when bottom line growth clocks in at less than 5%, the S&P jumps more than 12% on average. The point: Over the long-term, stock prices are obviously correlated to earnings growth, but equities and profits typically move in opposite directions in real time.

In 2018, profit growth was among the best on record, and yet stocks suffered their worst performance since the crisis, for example. In 2019, stocks rose an astounding ~30% even as profit growth all but flatlined.

Even if this explanation is only partially accurate, it means that some of the gains logged by equities last year were predicated on the notion that profit growth would inflect sharply for the better following the first earnings recession in three years.

Technically, it wasn’t quite an earnings recession, but as the blue bars in the “shattered dreams” chart show, it was close enough.

Now what? That is: If stocks were anticipating an inflection in profits, they were “wrong”, but mostly because Mother Nature intervened. The green-shaded area in the visual represents the expected pre-pandemic trajectory of EPS growth. The red-shaded area shows you what consensus expects now.

There’s a sense in which things can only get better, and if you buy into the idea that stocks are efficient at pricing the future, it makes sense that they’d be up. This is, in essence anyway, the argument made by the likes of Morgan Stanley.

But even as we all realize that things cannot possibly get much worse (it’s hard to imagine, for instance, a scenario where YoY profit growth is deeply negative again in 2021 considering how depressed 2020’s numbers are going to be), corporate management is having a demonstrably difficult time quantifying the future.

Only 17 companies braved guidance in June, leaving analysts with an “n” that simply isn’t large enough to work with. BofA called it “too sparse to analyze”, noting that “corporate sentiment is neither positive nor negative, but simply a big question mark”.

The chart below is chuckle-inducing. It’s not so much the obvious joke in the header that’s funny as it is the accidental humor inherent in the subheader. There’s something amusing about a time series called “instances of guidance”, and that series having fallen completely off a cliff.

This is made all the more convoluted by the fact that the surge in equity prices since the March lows (ostensibly on the idea that profit expectations can’t possibly fall much further) means any disappointments risk triggering a kind of automatic upward reset to already sky-high multiples.

“The pressure to deliver good news is higher this time around, thanks to what’s happened to prices”, Bloomberg writes, in a piece that mentions the same BofA note. “The S&P 500 has jumped 24% since this time last quarter, adding $10 trillion to share values, and its forward valuations expanded at twice that rate — from 16.5 times estimated profit to 25 times”.

If profit forecasts have troughed, valuations will fall as NTM EPS rebounds, but what happens if companies start issuing guidance and it somehow manages to undershoot? Or results come in worse than expected, prompting another wave of cuts to analysts’ forecasts?

More to the point: Who is going to be comfortable buying SPX at ~30x amid rampant uncertainty around the economy, a pause in the re-opening push, and polls which suggest Trump’s presidency (and the corporate tax cuts that went along with it) may soon be relegated to the dustbin of history?

If there’s going to be a Wile E. Coyote moment, that may be it.