Delayed Reckoning

Earnings, and particularly forward estimates, were the proverbial next shoe to drop.

And then, suddenly, they weren’t.

According to some top-down strategists, Q2 reporting season should’ve marked a profit reckoning as the combination of margin headwinds and a deteriorating growth outlook prompted guide downs and, ultimately, a tsunami of analyst revisions. Ironically, such warnings were voluble enough to prod management into preemptive damage control. Or so goes one version of the story.

“While most investors remain preoccupied with the Fed and their next move, we have been more focused on earnings and the risk to forward estimates,” Morgan Stanley’s Mike Wilson wrote Monday, in the course of suggesting the summer equity rally is now likely over. “In June, many investors began to share our concern, which is why stocks sold off so sharply, in our view,” he added, noting that “companies began managing the quarter lower and by the time Q2 earnings season rolled around, positioning was quite bearish [leading] to the ‘bad news is good news’ rally or as many people claimed, ‘better than feared’ results.”

Wilson believes it’s just a matter of time before forward earnings forecasts are revised materially lower, and as it turns out, seasonality favors that view. “The period running from mid-September through December is a particularly challenging time for estimates,” he wrote. As the figure (below) shows, next calendar year estimates were revised lower almost three quarters of the time from late August through December going back nearly a quarter century.

I’m sure there are any number of explanations for that (typically, estimates are revised down throughout the year, so it could be that analysts wait until the back half to deliver the majority of bad news they’d rather not deliver), but the more important consideration in 2022 is that headwinds to profitability are multitudinous.

In simple terms: The combination of elevated input costs (including and especially labor) and slower growth bodes ill. Toss in rising rates, a hostile political environment vis-à-vis corporate taxes and any incremental drag from the buyback excise tax, and you’re left to ponder a challenging road ahead. The two tables (below, from Goldman) give you the lay of the land, so to speak.

“As the entirety of the equities down-trade in 2022 [was due to] tighter financial conditions and Fed-hiking impact on multiples, it seems the market is again turning its gaze towards Q3 negative earnings revisions as the driver of the ‘next leg down’ on risk of lower profit margins and lower earnings growth as the slowdown bites,” Nomura’s Charlie McElligott wrote Monday.

“17.5 times $230 = 4,025, which just happens to be current spot,” Charlie went on to say, running through various valuation-EPS permutations. “In light of the belief that earnings are soon to begin moving lower on the ‘variable and lagged’ impact of FCI tightening, 17.5 times $225 goes to 3,937, with the local low-end being 3,850 (17.5 times $220).”

For what it’s worth, Morgan Stanley’s June 2023 price target for the index is 3,900. Wilson’s bear case is 3,350 or around 16x on $212 in earnings. His bull case, which assumes an 18 multiple on $249 in aggregate profits, is 4,450.