Why The Risk Of Profit Letdowns Has Never Been Higher

Never has the risk of downside earnings surprises from corporate America been greater.

Or at least according to the stark juxtaposition between one bank’s leading indicator and bottom-up consensus forecasts.

As regular readers are acutely aware, there’s palpable concern among some top-down equity strategists on Wall Street that the collective “wisdom” of company analysts materially understates the odds of a deep profit recession.

The reason for that concern is straightforward: Company analysts take their cues from management, and the C-suite isn’t inclined to deliver bad news unless and until it’s absolutely necessary. Or unless and until it’s too late, if you enjoy hyperbole.

To the extent the symbiotic relationship between the C-suite and analysts is manifesting in complacency among the latter, it’s an issue. Last year, the dynamic was derided as appalling by Morgan Stanley Wealth Management CIO Lisa Shalett. “It’s horrifying there is very little proactivity among bottom-up analysts to go out on a limb and cut numbers without corporate management telling them exactly what to do,” she told Bloomberg television in June. “That’s problematic in terms of their value proposition to investors.”

With that in mind, note that management teams appear to be feeling at least incrementally better about their capacity to protect margins in an environment when cost pressures remain acute, but pricing power is dwindling. That uptick in confidence may be supporting forward earnings estimates which, in turn, risks emboldening investors at a perilous juncture.

That’s according to Shalett’s colleague Mike Wilson. “One of the reasons we think investors are more confident in the soft landing or at least not as bad of an earnings outcome as we are forecasting is that company management teams have started to sound more confident in their ability to manage costs and the negative operating leverage cycle,” he said Tuesday.

As you can imagine, Wilson is skeptical. CEOs, he politely noted, “have never operated in such a unique and difficult environment,” and that means they could be just as taken aback by the downside from negative operating leverage as they were “by the upside in margins and profits in 2020 and 2021.”

That brings us to the bank’s non-PMI leading earnings indicator and, more importantly, to the spread versus consensus. Long story short, it’s never been wider.

“Consensus bottom-up forecasts are heavily based on company guidance,” Wilson wrote, in the course of warning that the disparity between those forecasts and his indicator suggests “the risk for further surprises to the downside on earnings is nearly as significant as we have ever seen.”

That factoid is especially notable given that, as the visual shows, the history of the indicator dates prior to the tech bubble, which means it encompasses not just the financial crisis, but also the dot-com bust.

Speaking of tech, Wilson also pointed out that on a forward-looking basis, the rate of cost growth relative to top-line growth for the Nasdaq 100 is “accelerating” and yet, “consensus expects a sharp rebound in EPS growth through the back half of this year.”

Something doesn’t add up there. Robust earnings growth can’t peaceably coexist with costs outpacing sales. The equation won’t work.

At the same time, earnings for big-cap US tech are deteriorating rapidly, even as revenue growth is positive. When considered with near daily announcements of tech layoffs, the message is clear enough: The margin squeeze is real, and importantly, some tech CEOs aren’t accustomed to this sort of thing. As Wilson went on to say, the sector “has largely been incentivized to grow in the post-GFC era.”

And it’s not just tech. The same metric (i.e., the spread between forward 12-month cost and sales growth) is solidly positive for the S&P as well, and rising.

Finally, as if the case needed to be any stronger, note that if you plot the non-PMI earnings indicator mentioned above on a one-year lead with trailing S&P 500 earnings growth, they match up very neatly going back two decades, with one notable exception: 2023/2024. There, the disparity between the two is 35 percentage points or, as Wilson put it, “consensus expectations run directly counter to our model.”