A Bear Revisits August Of 2008

I think we all get the joke. Or jokes, plural.

Earnings are managed, management isn’t inclined to disappoint investors and company analysts aren’t inclined to cut forecasts until prompted by management. None of that’s a secret, but occasionally, it makes sense to feign incredulity.

Typically, disconnects between rosy profit estimates and less rosy macro conjunctures get a dismissive eye roll and little else. Because, again, it’s not a secret. As Morgan Stanley’s Mike Wilson put it Monday, “company management teams are loath to deliver bad news to investors until they have to, particularly on out-year forecasts, which is what really drives the index price.”

Under normal circumstances, excoriating company analysts for not proactively cutting estimates and price targets in their coverage universe is to be deliberately obtuse. That’s not what they do. We can pretend, but there’s not much utility in it. Or at least not usually.

Sometimes, though, the disconnect between profit estimates and the macro outlook becomes so glaring that ignoring it (or giving it the usual dismissive eye roll) could be perilous. When those moments arrive, there’s some utility in calling it out. Such was the case headed into Q2 reporting season. The macro outlook was laughably fraught (assuming you can find humor in misery of every sort) and yet, when rolled up and aggregated, year-ahead profit forecasts suggested nothing at all was amiss. Hence week after week of light hyperbole and caustic scoldings.

As it turns out, the hyperbole and scoldings were misplaced or, more likely, too early. Q2 earnings season hasn’t been the disastrous affair many observers (myself included) feared it might be. Over the weekend, in “I Was Told There’d Be Drama,” I updated some figures on beats and misses on the way to noting that, “Next week will invariably bring more revisions breadth charts using various leads and lags to show how close we are to something bad.”

Sure enough, Morgan’s Wilson delivered. “Earnings revisions breadth has dropped precipitously over the last month falling nearly 15% to -20%,” he said. The figures (below) are updated, but they look quite a bit like they did last week.

“Earnings revisions breadth tends to lead forward earnings growth lower and the earnings correction has only just begun,” Wilson wrote. “The substantial drop in revisions breadth gives our team high conviction that the current risk to earnings hasn’t fully made its way into the estimates yet.”

I assume this is (still) obvious, but I generally agree with Wilson. The problem is that this is tomorrow’s news, where tomorrow means next quarter or the quarter after that. And, as the old saying goes, tomorrow isn’t promised. So while I do generally buy the notion that this is a foregone conclusion, I’ve been surprised by corporate pricing power thus far. And the recession narrative is now so consensus as to make me somewhat uncomfortable with it.

On Monday, Wilson leveraged the visceral fear of the financial crisis to make his point. “As an example of just how slow these consensus numbers are to reflect reality, it may be instructive to look more closely at the period just before the GFC began in earnest,” he wrote, before reliving August of 2008:

The macro environment was terrible — the housing market had already imploded with rampant foreclosures, Bear Stearns had gone bankrupt five months earlier and most of the banking system was a mess, along with consumer balance sheets. Meanwhile, many key macro data points that are closely aligned with the price of the S&P 500 were slightly worse than we are seeing today but not materially. Perhaps the biggest “tell” that supports our take that forward estimates for the S&P 500 are slower to come down than they should be is the fact that bottom-up NTM EPS in early August 2008 were down just 4% at that time from the peak. It’s almost hard to fathom how estimates weren’t already lower in August 2008 given what was going on.

While conceding the gist of Wilson’s retrospective, I’d remind readers that everything is obvious in hindsight.

At the time (i.e., in August of 2008), the writing was on the wall, but it’s not terribly hard to fathom the willful blindness. In an everyday sense of the concept (as opposed to the legal sense), willful blindness is a psychological survival mechanism. The tragic irony is that while it protects and preserves our sanity, it often leads us to physical and financial ruin.

In any event, Wilson was keen to emphasize that the point in revisiting August of 2008 wasn’t to suggest another crisis is imminent. Rather, he wanted to “illustrate just how slow the forward estimates are to come down even in a situation as dire as 2008 when everyone knew it was terrible.” Assuming the US is either in a recession or about to enter a recession “this time is unlikely to be much different,” he said.

What would be different, though, is the government’s capacity to counter any downturn. As Wilson pointed out, the Fed’s balance sheet was just $900 billion in August of 2008 versus $9 trillion now. And America’s debt/GDP ratio has doubled since then.

Memoir from September 2008: Where Were You When The World Didn’t End?