“In bear markets like last year’s, when just about everyone lost money, investors lose confidence,” Morgan Stanley’s Mike Wilson said, in his latest note, exhorting market participants to “ignore the noise” and trust the process.
Of course, if your process is flawed, that strategy isn’t likely to be effective, but Wilson’s process was spot-on in 2022, so he can hardly be blamed for leaning on it amid persistent macro ambiguity and uneven corporate earnings.
Around 14% of S&P 500 market cap (11% of companies) had reported headed into this week. The results weren’t especially encouraging when considered together. 44% beat by at least one standard deviation relative to consensus, according to Goldman’s calculations, well below levels seen during recent quarters. Only 60% of 55 companies reporting managed an absolute beat, down markedly from the 76% seen just three quarters ago.
Q4 EPS came into this week tracking a 1% miss versus the historical average beat post-Week 1, BofA’s Savita Subramanian said, calling attention to the lowered bar: “And this is after a 7% cut into the season.”
For Wilson, the profit reckoning is just beginning. “Suffice it to say, we’re not biting on this recent rally because our work and process are so convincingly bearish on earnings,” he wrote, reminding investors that the bank’s conviction doesn’t hinge on the timing of any US economic recession. Indeed, it doesn’t even hang on a recession happening in 2023 at all.
Instead, it’s all about margins and negative operating leverage. In that regard, “the evidence is mounting,” Wilson said.
Revenue could “fall off quickly and unexpectedly, while costs remain sticky in the short-term,” he warned, pointing to bloated inventories and “less productive headcount” as “the primary culprits.” That deleterious conjuncture is already visible in some industries even before the onset of an economic downturn.
The bank’s models have a good track record. Currently, the disconnect between their non-PMI leading EPS indicator and consensus is approaching levels which presaged huge declines for US equities in the past.
I think it’s fair to say a repeat of the 2008 experience is unlikely in the absence of a systemic shock, but Wilson’s point is just that the bank’s model will probably be right directionally.
“It’s simply a matter of timing and magnitude, and we think the earnings recession is imminent,” he said, encouraging market participants to “stay focused on fundamentals and ignore the false signals and misleading reflections in this bear market hall of mirrors.”
Morgan Stanley expects new lows for the S&P, after which the bear market should come to an end “later this quarter or early in Q2.”
Wilson makes a very compelling case, other analysts have added good insight as well into a likely earnings recession. I personally agree with the direction lower for major indices but I’m not convinced it is an H1 event, will be rolling my puts to give myself more time, H2 is looking more likely for a selloff, when we could get a mix of clear earnings deterioration with an obstinate Fed holding rates steady despite markets pricing cuts. Not a bullish combo.
Timing for me could be sooner or later. Doesn’t matter for my style of investing. For me, the key statement is to “stay focused on fundamentals and ignore the false signals and misleading reflections in this bear market hall of mirrors.”
It’s easy enough to foresee that things are going to happen to earnings. My only question is whether the world economy may have to deal with complicating factors related to the war in Ukraine.
Russia today is no longer a constructive member of the world economy, and they’re having very serious impacts on their economy. Will someone please point out to Russia the benefits of getting rid of Putin and becoming a constructive part of the world economy again? They will only lose favor and lose the war if they persist in Ukraine. And if they do persist, I believe it will be only a matter of time before US troops currently in Poland will push into Ukraine.
One good thing: the war is hastening consciousness about the need change how the world sources energy. US oil companies right now are shining. But this may be their last hurrah.
The temperature of the US economy will go down. The US will get over its economic fever by the end of the summer if other matters (like Iran entering the war or Germany withholding tanks) do not intrude.
It IS a very compelling case, but the market reminds me of trying to hold a beach ball under water.
The technicals seem to favor those who’s job it is not to think/analyze/forecast, but LDIs and others whose job it is to just keep their portfolios invested. Additionally, stocks are increasingly owned by the ultra HNW investors, whose need to generate disposable income is low relative to the size of their “permanent portfolios”. They have so much wealth, they don’t need to be defensive in the short run, because in the long run, markets go up. Maybe Wilson is right, eventually, but I think it is likely we see a short capitulation trade going into month end.
Assuming the indicated -25% variance from consensus growth estimates turns out, it will be interesting to see the market’s reaction as this unfolds. Of various sentiment factors, I suspect several will lead the market to look beyond earnings and limit downside:
earnings recession duration – if the market sees even a significant earns decline as a 1 or 2 quarter episode then I doubt we will come even close to prior lows.
inflation stickiness: If recent commentary is correct, the Dec upturns in some commodities, and continued loosening of FCI may mean inflation data upside surprise as soon as Feb/Mar. I’m more concerned about this than an earns recession as it is the one factor the market absolutely won’t look beyond.
Ukraine: recent commentary that a Ukr spring offensive, the western weapons surge, and doubt that a 2nd Russian mobilization will occur in time for 2023 offensive (certainly not by spring), and may even be channeled into a post-war military rebuild, may get the market to starting factoring in a possible end-2023ish war settlement favoring Ukr.
China: a solid positive going forward. Covid’s already a fading factor, property has been and will continue to be managed. My canary for political risk is the PCAOB issue, which is currently reading “favorable”. I expect political approach of senior leadership to continue shifting incrementally positive.
Unless inflation starts going wrong-way, I suspect the earnings story may have status of “not bad enough”.
Staying focused on fundamentals, identifying the false signals to be ignored and putting guide posts in the hall of mirrors is why I follow Mr. H’s writings daily. I don’t expect him to be perfect but a lot closer than I would ever be without the aid of hindsight.