The problem is one I’ve been banging on about all year: Investors still aren’t factoring in much threat to earnings, even though recessions almost always hit earnings hard. Instead, most of the fall in stock prices has been due to rising rates lowering valuations. There’s been an acceptance of slightly lower earnings for this year, at least when the oil windfall boosting energy companies is excluded, but Wall Street continues to predict decent profit growth next year.
Put another way: Investors still hope for a fairly soft landing. The problem is that the Fed has clearly lost confidence in its own ability to engineer an economic slowdown that avoids recession. As that message sinks in, expect stock prices to sink further.
The key question, of course, is how much risk to earnings is priced in already. After all, stocks are down 20% this year and only 3% above their June low, confirming that the bear market continues.
One approach is to compare now to before the pandemic. Of the current members of the S&P 500, 85% have higher forecast earnings per share for the next 12 months than they did in February 2020. At the same time, 81% trade at lower multiples of those forecasts.
This divergence reflects two obvious factors, and a third up for debate. The first is the pandemic itself, which boosted the earnings of many of the tech firms that dominate the market, and overall profit margins. The second is the valuation of their future growth, reduced by the Fed pushing up interest rates.
The third factor that explains the difference is the risk to future growth. Earnings forecasts don’t come with probabilities, so if I think there’s more danger of a recession I should put less value on those future earnings. The bull case would be that this is already happening, hence the lower valuation, so investors won’t be shocked by a recession. After all, a majority of fund managers surveyed by
already say that a recession is likely, the highest since 2020 and before that 2009.
There is definitely some of this recession prep going on. But the strong link between forward price-to-earnings ratios and real rates, as captured by the yield on 10-year Treasury inflation-protected securities, shows that still most of the decline in stocks this year wasn’t about the threat to earnings, merely the mechanical effect of the Fed. That’s backed up by the biggest losers being the most extreme growth stocks, which in principle ought to be less affected by recession than sellers of less innovative products.
There hasn’t been a lot of recession preparation in the bond markets, either. The most reliable bond market predictor of downturns is the three-month Treasury bill yield rising above the 10-year yield, which has yet to happen. A bit of worry was visible in the bond market on Wednesday, with the 10-year yield dropping even as the two-year yield rose—implying investors expect higher rates to slow the economy enough to allow lower rates on average over the decade—but such moves have been rare this year.
It’s also hard to price a recession when there’s so much money sloshing around and the jobs market is so strong. Pandemic-era savings are being used up but are still high. There are almost two job vacancies for every job seeker, and despite the drumbeat of big companies cutting back staff, last week initial jobless claims hit their lowest level since 1969, when not adjusted for seasonality. Those paid hourly who switched job got a median pay rise of 8.4% annualized in the three months to August, according to the Atlanta Fed, the highest since its data started in 1997 and higher than the Fed’s preferred measure of inflation.
In normal times this would be great news. Strong consumers mean a stronger economy, higher profits even after paying bigger wages and good times on Wall Street. But when the Fed is deliberately trying to weaken the job market and limit wage rises, signs of strength in the economy just mean even more Fed action is needed to crush it.
My view is that the markets are doing what they always do, hoping against hope that there’s no recession, or at least a very mild one, right up to the last minute. I was hoping for such a benign outcome earlier this year, but it now seems unlikely. Historically it has occasionally worked out, as in the 1990 recession, when earnings barely dropped and the S&P bottomed out with a 19.9% fall, or the 1994 soft landing, when stocks fell less than 10%.
Usually it doesn’t work out, however, and the drop in valuations is merely the first step, as recession eviscerates earnings expectations and leads to another leg down in share prices. I’ll be a buyer when a recession like this starts to be priced in.
Write to James Mackintosh at email@example.com
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