Earnings season is upon us, and that’s not necessarily a good thing.
The “profit reckoning” predicted by so many top-down strategists headed into Q2 results didn’t materialize, in part because management did an admirable job of lowering the bar.
But, there’s only so far this particular can be kicked, especially considering the lagged impact on revenues from an ever stronger USD. “The most common phrase during upcoming Q3 earnings calls will be ‘but on a constant currency basis…,'” Goldman’s David Kostin said.
For what it’s worth, YoY EPS growth was more than double expectations in Q1 and 50% higher in Q2. An encore will be challenging, all “adjustments” and gimmickry aside. Margin headwinds are myriad, the currency drag is onerous and guides are likely to be cautious.
The figure (below) gives you some context, both backward and forward looking. Consensus did come down materially over the course of the third quarter (see the annotation), but analysts aren’t expecting anything like a profit armageddon (the orange bars are bottom-up consensus out to Q4 2023).
As of Q2, S&P 500 net margins were 12.4% on a trailing four-quarter basis, a record. As Kostin noted, “analysts still expect margin expansion in 2023 relative to 2022 despite persistent input cost pressures and elevated wage growth.”
The list of companies who’ve delivered some manner of warning over the past two months is long indeed. Reports of hiring freezes and job cuts are pervasive. 10% of index market cap has preannounced, according to Goldman. Kostin called that “consistent with prior periods of high uncertainty” before again adopting a somewhat incredulous cadence in noting that despite efforts on the part of corporates to “manage investor expectations,” cuts to Q4 earnings estimates amount to just 1% so far in 2022. Analysts still expect 7% YoY growth during the current quarter.
As mentioned above, estimates for Q3 did come down. The figure on the left (below, from Goldman), shows the evolution of consensus. Since July, the outlook for this quarter’s EPS growth has fallen from 10% to 3% — “not nothin’,” as they say.
“The major culprit” was a less optimistic outlook for margins, Goldman noted. When Q3 began, consensus expected 20bps of margin expansion, to a new record of 12.7%. Fast forward three months and that projection is 11.8%.
And yet, company analysts are undaunted. Or at least when it comes to next year. Looking into 2023, the optimism vis-à-vis corporate profitability borders on the Pollyanna-ish. Aggregate earnings growth is seen at 7% for the full year on 5% top line growth and 11bps worth of margin expansion. That, in an environment which is almost guaranteed to include the beginnings of a genuine NBER recession.
For his part, Goldman’s Kostin is less sanguine. He sees 3% profit growth in 2023 in a soft landing scenario, accompanied by 25bps of margin compression. In a hard landing, earnings would fall 11% and margins would contract by more than 125bps, according to Goldman.
The figure on the right (above) gives you a sense of the impact the stronger dollar has on top line beats. The relationship is fairly robust. And that’s not a good thing currently. Corporates are facing a currency headwind on the top line just as higher input costs (from labor to raw materials) and rising rates are hurting profitability. It’s a bad combination.
A small handful of big names report on Wednesday and Thursday, but the real “fun” starts Friday, with JPMorgan, Morgan Stanley and Citi.
“As of Q2, S&P 500 net margins were 12.4% on a trailing four-quarter basis, a record. As Kostin noted, ‘analysts still expect margin expansion in 2023 relative to 2022 despite persistent input cost pressures and elevated wage growth.'”
If Kostin’s comment is true than it necessarily implies that firms are successfully increasing prices sufficiently to counteract rising input costs. So much for reducing inflation. This statement implies inflation of the cost-push variety, hard to put the brakes on with rates of only 4.5%. We will need a Volcker-sized nuke.
Not sure firms can pass on all costs. Or sustain profits/margins. It will be difficult to kick the can down the road,
Semiconductor companies often act like the canary in the coal mine, precursors of a slowly economy and a consumer that is cutting back on discretionary purchases.
Some important bell weather companies announced important revenue fall-offs in the last quarter. And the mobile phone market is set for a down year.
Forecasted revenue only 3 months forward is off by double digits and companies are now racking up charges for excess chip inventory in the hundreds of millions and alerting shareholders of possible losses in the coming quarters.
Funny how only 6 months ago, these companies were selling all the chips they could make. But are now struggling to deal with excess inventory, reducing capital spending and cutting production.
At least some of that is due to the ‘crypto winter’
Certainly a factor, but there are many other factors inflicting a lot more pain on consumers who drive the economy.
According to one article
“As of June 13, the general crypto market capitalisation was at $964 billion, dropping from $2.16 billion recorded on January 1, a loss of over 55% or $1.19 trillion, according to CoinMarketCap data. ” (https://finbold.com/crypto-market-loses-55-of-its-capitalisation-in-2022-as-bitcoin-drops-below-24k/)
However, these amounts pale in comparison to stock market losses in the US alone as of the end of Sept. 2022.
“.. market experts say the current wealth losses from financial markets could total $9.5 trillion to $10 trillion. ”
(https://www.cnbc.com/2022/09/27/stock-market-losses-wipe-out-9-trillion-from-americans-wealth-.html)
So yes, investors are feeling poorer, facing the brunt of much higher mortgage costs if they are having to renew and will have less cash in their pockets due to increases in costs of non-discretionary items (food, rent/housing, utilities and fuel) and credit.
The losses in household equities were almost $11 trillion over H1 (they were almost $8 trillion in Q2 alone): https://heisenbergreport.com/wp-content/uploads/2022/09/HouseholdEquityValuesQ22022.png
When you toss in Q3, they’re far larger.
If you add the crypto wipeout they’re larger still. Add in the worst bond bear market in modern history and the worst year for IG corporate credit on record, and the losses are probably ~$25 trillion for “households” depending on how narrow your definition of “households” is.
The global market cap of stocks and bonds was still down ~$36 trillion as of last week. The GFC wasn’t even close to that.
Lucky One – maybe we should be looking at the margins, excluding oil companies.
The pace of Fed rate hikes is clearly affecting the consumer. While the Fed with its single-minded focus on inflation, shows no sign of relenting and seems ready and determined to break the economy and the stock market to reach its inflation target.
As far as the financial markets go, the possibility of a financial monetary crises (that no one sees coming) brought on by the rising rates and/or strong USD may cause the Fed to pivot.
My problem and questions would then not be about a Fed pivot on rate hikes. But rather, who are they bailing out now, why and what will it cost? Is it going to be to over-leveraged bankers, pension managers, funds, …. who gambled and lost investors’ money?
Will we see a repeat along the lines of the subprime mortgage crises of 2007-2008? Financial institutions, regulators, credit agencies, government housing policies, and consumers all played a role. But it seems only the consumer suffered the real consequences and got the least help from the government. Did bankers CEOs/CFOs do jail time for risking clients’ money on bad loans? What about rating agencies giving attractive ratings to mortgage-backed securities that were not investment grade. And regulatory agencies and government officials who seemed oblivious to it all.
A crude “back of envelope” valuation framework, with some example numbers plugged in.
The example numbers plugged into the example below are only one possible scenario (mild recession, margin reversion, long rates don’t go much higher, etc). Can plug own assumptions into this framework, for deeper/shallower recession, greater/lesser revenue decline, whatever. Then consider how much SP500 may undershoot fair value, which I think is more of a liquidity issue than anything amenable to fundamental analysis.
SP500 2023 EPS
– Revenue -5% from 1819 consensus 2022E -> 1659 scenario 2023E rev (assume decline of -5% is between 2009’s -10% and 2002’s +0.4%)
– Scenario 2023E EBIT margin 15.5% (assume revert to pre-Covid level, from consensus 2022E 16.99%) -> 257 scenario 2023E EBIT (or -13% decline from consensus 2022E 297)
– Compare to consensus 2023E 17.33% EBIT margin on 1819 rev -> 314 consensus 2023E EBIT
– 257 / 314 = 0.82 or scenario 2023E EBIT -18.4% below consensus 2023E EBIT
– 81.6% of consensus 2023E EPS 239 -> scenario 2023E EPS 195 (compare to consensus 2023E EPS 239)
SP500 P/E
– Risk-free (rF) = 4%, equity risk premium (ERP) = 6%, so cost of equity = 4% + 6% = 10% (granted ERP is opaque, but 6% is a lot)
– Spread corporates to UST 200 bp, so cost of debt = 4% + 2% = 6%
– SP500 tax rate = 18%
– SP500 capital structure equity 80% debt 20%
– Weight average cost of capital (WACC) = 0.8 * 0.10 + 0.2* 0.06 * ( 1 – 0.18) = 0.089 or 8.9%
– Perpetuity growth of earnings (g) assume 3.0% (assume over long term SP500 grows earnings 1 ppt over inflation rate, and inflation reverts to 2%)
– Present value of $1 of current earnings at perpetuity growth = 1 / ( WACC – g ) = 1 ( 0.089 – 0.030) = 16.7, which is PE
SP500 value
– PE 16.7 X EPS 195 = 3257 (“fair value”)
– If 10% undershoot, 3257 * 0.90 = 2932 (“downside target”)
As far as timing, referring to SP500
– estimates for 2003 bottomed out in 1H2003, while price bottomed 10/2002.
– estimates for 2016 bottomed in mid-2016 while price bottomed 2/2016.
– estimates for 2009 bottomed in 2Q2009 while price bottomed 3/2009.
The “lead” from price bottom to estimates bottom was between a couple months and several months. Which is fairly consistent with the old rule of thumb that the market leads by around 6 months.
The implication is that if you think SP500 estimates will bottom out in mid 2023, you might look for SP500 price to bottom somewhere between now and 1Q2023.
I expect lots of buysiders are rooting for earnings wipeouts and guidance pukes this month, because they’ve taken their portfolios as defensive as their strategy permits, and would like to get the losing done in 2022. I would like that too, but suspect it will take more than one quarter to haul 2023 estimates down by almost -20% from current.
The thing I am fearing the most right now is upside surprises against bearish sentiment. A 4Q bear market rally would catch a lot of people flatfooted.