Beware Acute Downgrade Risk As Profit Reckoning Looms

Hopeless.

That’s how I’d characterize forward earnings estimates headed into Q2 reporting season in the US.

I’ve written voluminously on this over the past several weeks. Much as it’s too late for Fed policymakers and Biden administration officials to get out ahead of a technical US recession which, depending on the evolution of the data over the next two weeks, could be a virtual lock by the time the BEA releases the advance estimate later this month, it’s too late for fundamental company analysts to mark estimates to economic reality.

This could all seem alarmist and hyperbolic in hindsight, but the dance between management, analysts and investors is typically well choreographed. Generally speaking, bars are set such that most companies clear them, leading to an aggregate beat, which then “informs” bullish forecasts for benchmark indexes.

That dynamic is at risk in Q2 and Q3. Many companies over-earned during the post-pandemic recovery, and margins are being squeezed on multiple fronts. I won’t spend an inordinate amount of time recapitulating given how often I’ve broached this subject of late, but I did want to highlight two simple charts (below) from Morgan Stanley’s Mike Wilson.

The overshoot versus the post-financial crisis trend is 20% or more for S&P 500 and Nasdaq 100 forward earnings estimates.

That, against the most daunting backdrop for margins in modern history, pervasive macro uncertainty and rising recession odds which, you’re gently reminded, management tends to incorporate into guidance even if any burgeoning slowdown hasn’t yet impacted operating results.

At the risk of trafficking in the kind of hyperbole I openly disavow, that’s a recipe for disaster. Someone, somewhere (and probably a lot of someones) is going to get blindsided in their coverage universe. Unfortunately for investors, analysts’ collective failure to preemptively trim forecasts raises the risk of a panicked wave of downgrades as results roll in. Those downgrades would likely exacerbate selloffs, a process that could become self-reinforcing.

In his latest, Morgan’s Wilson pointed to Q1’s decline in NIPA profits (figure below), the first drop since the onset of the pandemic. “There’s some precedent that NIPA declines could precede S&P 500 earnings cuts,” he wrote, noting that during the dot-com bust and the GFC, NIPA profits led S&P EPS by about a year.

Some readers will suggest that’s apples to oranges. If that’s you, you’re not wrong. But you’re not totally right either. And in any event, Wilson acknowledged the myriad compositional differences that make comparison difficult.

This isn’t about any one specific indicator or “canary,” if you like. It’s about the totality of evidence and the glaring disparity between forward estimates and trend.

“We recognize that NIPA profits differ in size, scope and accounting measures from S&P 500 profitability, so we take this relationship with a grain of salt,” Wilson wrote. “However, we are intrigued that this change in trend is occurring as we see earnings revisions breadth, a leading indicator, falling into negative territory and a more consensus view for EPS cuts among our clients.”


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5 thoughts on “Beware Acute Downgrade Risk As Profit Reckoning Looms

  1. Its almost as if the small-time retail investor (me!) is intentionally being left holding the bag. Gotta put us back in our place for the sake of the economy, i guess.

    1. @derek and it will be soooo nice (when earnings matter again)!

      I don’t have the data handy, but any thoughts on which qtr will see the largest negative estimate revisions? I think normally it is 3Q, because mgmts and analysts have run out of wishful thinking room for the FY. This time, maybe 2Q will get its fair share.

  2. Do analysts matter to the Whales? (I mean the real market movers like Blackrock, CalPers, etc)
    So many times they pick target prices that are astronomical “1 year targets” and 3 months later double or halve it, almost orthogonal of the actual companies finance or outlook?
    Glad to see Wilson sounds like a voice of reason – not sure this market is reasonable yet.

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