Bank Earnings Start Off With a Thud, Expect Things Will Get Worse

Bloomberg reports Earnings Season Will Hang on Price-to-Recession

We can’t shake off the horrors of 2022 just yet; the season for announcing the earnings for the fourth quarter of last year is about to begin. As these are also full-year results, they tend to be the most tightly audited, and CEOs themselves are more likely to appear on earnings calls. This will be their opportunity to own up to the full extent of 2022’s damage and — more importantly — reveal what they’re bracing for this year.

Globally, economies are slowing down, affecting profits of S&P 500 companies and increasing recession risks. All of this has played out into unusually gloomy earnings sentiment as the announcements approach. This chart is from David Kostin, chief US equity strategist at Goldman Sachs, and shows downward revisions running at a rate which in recent years has presaged a recession.

But as bad as investors are bracing themselves for the fourth quarter, earnings for the year ahead may be much worse. Around half of the respondents Bloomberg surveyed expect results that will be posted from April to June to reflect the impact of a potential economic contraction.

Another issue is margins, which traditionally tended to be highly mean-reverting. With workers apparently in a stronger position since the pandemic, that should mean tighter margins for shareholders. However, the consensus expects margins to expand again and contribute positively to earnings growth during 2023. To strategists at Strategas Securities led by Ryan Grabinski, however, that sounds “overly optimistic”:

Cost pressures are likely to remain sticky and activity, as shown in the ISM surveys over the past few months, is likely to continue to slow. This is usually not an environment where margins would expand and is further evidence to us that EPS remain too high.

Many analysts analyze a stock’s price-to-earnings (P/E) ratio, or the P/E for the aggregate market, using forward earnings for the next quarter or next year, which are built on a foundation of recent past operating earnings.

So, what’s wrong with this approach?

These assumptions introduce a large bias into aggregate market earnings, hence, into aggregate market P/E ratios. In practice, companies choose to exclude far more negative extraordinary items than positive, which has led some analysts to whimsically describe operating earnings as “earnings before whatever went wrong.”

As a result, estimates of individual companies’ future reported earnings—when aggregated across the full market—will reliably overstate aggregate future market earnings and understate the aggregate market P/E ratio. Over the last 34 years, data provided by S&P show that aggregate S&P 500 reported earnings have been an average 5% lower than prior-year operating earnings, despite powerful growth in both reported and operating earnings over the same span.

The same-year comparison is even larger: concurrent reported earnings are lower than operating earnings by 13%. This gap between operating earnings and reported earnings becomes more extreme in recessions.

It is easy to see why we occasionally refer to the P/F ratio as the Price/Fantasy ratio.

What About Rate Cuts?

The stock market has been rallying around the idea of rate cuts.

If and when the cuts come it will be because the economy is so bad the Fed can’t take it anymore.

What would that mean to earnings?

And on the inflation front, please consider “America First”, Biden and Trump Both Guilty of Sponsoring Inflation

This post originated at MishTalk.Com