“Despite recession fears, S&P 500 consensus 2022 and 2023 EPS estimates have both been revised up so far this year,” Goldman’s David Kostin wrote, in his latest weekly. The emphasis on “up” is in the original.
Top-down strategists and CIOs are by now just as incredulous about the lack of capitulation from bottom-up consensus as many of the more caustic observers who deal in hyperbole. That is: The “serious” people are now just as concerned as the unserious about the possibility that company analysts are asleep at the proverbial wheel with just weeks to go before US corporate earnings start rolling in.
This story is a bit of a broken record, but much like the recession narrative that has so many market participants worried about analysts’ reluctance to proactively cut estimates, it’s so pervasive as to demand near daily attention. That’s the paradox of “known,” well-socialized risks: If they’re ubiquitous, they’re surely in the price, except when they aren’t, in which case failing to pound the table is to be complacent and derelict.
With that in mind, have a look at the figure (below) which shows expectations for corporate profitability.
The chart compares apples to oranges in a few respects, but that doesn’t dilute the overarching point, which is very straightforward: Analysts expect record profitability from corporate America despite the very real prospect of a shallow recession. Most importantly: Recession concerns are predicated almost entirely on factors that bode poorly for margins.
This conjuncture appears extremely incongruous. At a very basic level, protecting margins entails reducing the all-in cost of production or, failing that, raising prices to consumers. But every input — from materials to labor to the cost of debt — is getting more expensive. And consumers are grappling with double-digit inflation for food and energy.
This is (easily) the most challenging environment for corporate profitability in recent memory. And yet, company analysts aren’t responding. In some cases, they aren’t even responding to cautious commentary from management.
That latter point raises an even more disturbing question than that posed by Morgan Stanley Wealth Management CIO Lisa Shalett. Shalett asked (implicitly) what purpose bottom-up analysts serve if they only cut numbers when the C-suite tells them to expect crimped profits. What, then, are we to make of a bottom-up community which, collectively anyway, refuses to cut estimates in the face of uniformly cautious guidance?
Whatever the case, the current bear market is entirely valuation-driven. One way to view the situation is to suggest that with the bulk of the de-rating behind us, there’s scope for preemptive re-rating to offset any earnings weakness. But there’s a problem with that too — namely that stocks still aren’t cheap.
As the figure (above) shows, domestic equities are more expensive than they’ve been at the bottom of every, single other bear market in modern US history.
Of course, none of that means stocks won’t manage a better performance in the back half of 2022 than they did during H1. That’s a pretty low bar, after all, and a hypothetical first-time investor who’s buying the S&P now has pretty good odds of enjoying positive returns by year-end.
My point here is just to say that if you’re skeptical of the notion that the de-rating is over, history may be on your side.
And if you’re skeptical of the notion that corporate America is going to preserve margins into the teeth of a recession triggered by rampant supply factor-driven inflation, record low consumer sentiment and a Fed that arguably wants to shave another 15% to 20% off equity prices in the interest of curbing inflation via a reverse wealth effect, common sense is on your side too.
Perhaps many of the analyts are young and rely on recent market dynamics? After all, since 2009 earnings did not really matter to the stock market.
I recall that Goldman (?) issued research showing that something like 90% of stock market gains from 2009 through 2019 were attributable to P/E expansion and buybacks. The absolute total dollar amount of corporate profits hardly budged either.
So we see muscle memory among many analysts and investors. Will they be proven right yet again? They may, but keep in mind that the Fed is no longer your friend as it was over that period.
Age could very well have something to do with it. While I’m sure a bunch of the individual company analysts weren’t on Wall Street in 2001, you’d think a lot of the sector coverage is still supervised by people who’ve been around for a while. If not, then it’s entirely possible that a sizable percentage of the individual estimates that go into bottom-up consensus amount to “unsupervised” forecasts from people whose only experience with recession was COVID. Another reason this is problematic is that management tends to set the bar such that they can clear it going forward. If analysts don’t respond by setting the bar lower, they’re setting up their coverage universe for failure.
I still can’t understand this thing about analysts — stubborn, I guess. I took many finance courses from a gentleman who was a co-founder of the CFA and graded all their exams for more than a decade. In my day, it was only the analysts who would be right or wrong if a company missed the “Street forecast.” Their responsibility was to understand the company and report on it. Company results were never a “miss,” bad analysts were the ones who missed, and I still believe, rightfully so. A miss between a company and an analyst forecast should result in a fired analyst not a 40% dive in the stock. Security analysis is just that, it should expose reality in advance. Company performance also is what it is. Analyst are not company’s CEOs, they are outsiders whose job it is to help the punters understand the performance of the companies they cover. A look at the track records of these guys as successful stock pickers shows just how badly they do their jobs.
They’re not all “a travesty.” As I’m fond of reminding folks from time to time, at the end of the day people tend to perform in a way that they think is consistent with keeping their jobs. So, if there’s a discernible predisposition towards bullishness, there’s a reason for that. Historically, the reason is fairly simple: Stocks go up over time. That almost never gets mentioned. In the age of finance-focused social media, market participants have come to equate perpetual bearishness with being “smart” or contrarianism as tantamount to genius. In reality, being perpetually bearish post-Lehman has been a money-losing proposition, to put it mildly.
The ultimate irony is that many of the same people who’ve spent a dozen years implicitly (and in some cases explicitly) advised the public to sell equities or otherwise stay on the sidelines, simultaneously insisted that central banks were determined to drive all financial assets into the stratosphere. Never has there been a more poignant example of cognitive dissonance than spending every waking hour explaining how policymakers are intent on levitating asset prices and telling your audience (netizens or clients) to sell the exact same assets. Web portals who did that were monetizing clicks to pay their mortgages. As for analysts, the permabearish variety are never bottom-up, they’re always top-down, and they have large followings for their research because it entertains clients, not because clients actually take it seriously. It’s the same reason people read bearish web portals: It’s just tabloid fodder. No institutional investors take any of that stuff seriously even if they read it. If they did, they’d be derelict in their fiduciary responsibilities.
I say all of that in the interest of being intellectually honest. I adopt a skeptical cadence when I write, but the reality is that being bearish is usually the wrong call. Generally speaking, stocks go up, and while I’ve heard people make the (bizarre) argument that if indexes included companies that went bankrupt that wouldn’t be the case, that’s the most absurd exercise in question-begging imaginable.
My question currently is more about these specific circumstances (i.e., the macro conjuncture as it exists in 2022) and the possibility that many company analysts are simply too young to remember even one recession excluding the pandemic.
None of that is to downplay failures of various sorts on the sell-side, but too often we lose track of the fact that the majority of people just want to go to work, eat a sandwich, get a big paycheck and go home. Obviously the dynamics are different depending on what your job is on the sell-side. A day in the life of a trader or a star dealmaker is totally different from a day in the life of some analyst with a mundane job covering big box retailers.
One causal factor of a recession is declining profits. Companies cut spending to defend profit margins. Consumers cutting back spending for whatever reason is another. The Fed often plays the role of Mrs Oleary’s cow. A tell after the fact is stranded investment. The next downturn will reveal these items.
Some time in 1983 I went to a party at a stunning apartment overlooking Lincoln Center. For recent B-school grads. You can imagine how arrogant yet insecure most people were, all strutting about boasting of their early successes.
I enjoyed myself, first claiming I was an analyst covering the chemical toilet industry. “Johnny on the Spot is making a strong showing, but Port-O-San is still the Cadillac of the industry!”
When that only elicited responses like “Uh, That’s interesting, but I just spotted someone I need to catch up with. See you later.”
So I veered to claiming that I worked for a dry cleaning supply wholesaler. “You be amazed by how cut throat the plastic bag and wire hanger markets are.”
Since that garnered equally dismissive reactions, I pivoted to claiming that I was a critic of made-for-TV movies. (Remember those?) That drew a little more interest.
Coda – not long after that, a friend attended a party down in SOHO. When he mimicked me it drew much more interest. He was quickly surrounded by aspiring filmmakers and screen writers.
I do admire a sense of humour.
I’ve noticed another vexing phenomenon of sorts in the contrasting performance of two different stocks I own. One is an old school. mostly small defense contractor which has generally beaten analysts estimates during the pandemic (albeit downwardly revised), but has been explicit to a fault about all the supply and other issues they are struggling with. After every earnings call of late, the stock is slammed as much as 15 to 20 percent on these “concerns,” before it slowly recovers and heads into the next report with much the same set up. The other is a bigger but less profitable materials company which keeps missing estimates, but touts the favorable headwinds and all they are doing to navigate the pandemic. Until recently, this stock trended higher as analysts raised estimates despite their immediately prior misses. As this phenomenon has become more apparent to me, I’ve noticed it occurring when I check out headlines of other stocks that have been crushed despite decent reports, or others that have managed to survive what looks like devastating misses. When I read the earnings call transcripts, inevitably I find the former have tended to underscore all their pandemic frictions, while the latter have tended to gloss over them.