Look Out Below, Earnings Could Break the S&P 500
With second-quarter 2022 earnings reports already making news, the season, as it’s called, gets fully under way starting today. And while we’ve seen some good reports and some bad ones, none of them individually has moved the market one way or another. That’s about to change.
As the big corporate names that draw headlines report, investors are going to start reacting to bottom-line trends, and the market’s going to move one way or another.
Profit Margins Under the Microscope
Roaring inflation is going to focus analysts and investors on corporate profit margins. How input costs (materials, labor, capital) and companies’ ability or inability to pass along costs to consumers impacts margins will be right up there this season with bottom-line earnings news.
The blended net profit margin across S&P 500 companies in Q1/ 2022 came in at 12.1% . While one percentage point from the all-time high S&P 500 profit margin of 13.1% registered in Q2/ 2021, it was below Q4/ 2021’s 12.4% rate and the third quarter in a row where margins fell.
Consensus estimates are for margins to hold up and even expand through 2023. That’s not likely and typical of analysts’ optimism. That seems unfounded , especially since margins have been contracting and we are likely entering a recession.
Since 1970 the median peak to trough contraction in margins during recessions was 130 basis points ( or 1.3 percentage points).
If a recession started with Q1 2022’s negative 1.6% GDP print when profit margins were 12.1%, and the average contraction is 130 bps, at the trough, PMs are likely to fall to 10.8%, give or take. That would be below their 5-year average of 11.2%.
That puts profit margins in the spotlight this reporting season.
Net earnings will be even more important. Analysts are still optimistic about earnings this quarter. The consensus is for about 4.3% earnings growth in Q2 (that’s down from 6 months ago when the average earnings growth rate was supposed to be 15%). If analysts start cutting earnings estimates for Q3 while Q2 reports are coming out, which will happen if CEOs and CFOs hammer analysts and investors with negative guidance and warning rhetoric on their earnings calls, we’ll see hand wringing and towels thrown in the ring as markets plumb new lows.
How low could they go?
The S&P 500 (SPX) has earned an average of $54 per share over the last four quarters, moving between $53 to $ 55 per share per quarter. That annualizes to $216 per share, w hich is great.
How great? That run rate, a substantial record, is 33% greater than the pre-pandemic 2018-2019 earnings run rate average of $40.59 per quarter ( or $163 per share trailing).
Taking where SPX closed on June 30, 2022, at 3785, and dividing that by $216 a share, we get a trailing view of a potential forward PE (price earnings ratio) multiple of 17.5x on SPX.
The modern average – meaning, between the 1990s and now – PE on SPX is 19.5x . The post- WWII historical average is 14x. Over the last ten years, the multiple averaged 17.5x .
With SPX closing the first half of the year at 3785, assuming forward 12-month earnings of $216, SPX’s current PE at 17.5x is below the modern PE of 19.5x (and pointedly above the historical PE of 14x). And at 17.5x, slightly above the average of the two periods ( 16.75x) and right on the mark of the past ten years.
Two months ago, Wall Street’s estimate for the forward 12-month SPX earnings was $235 per share. That’s an 8.8% rise over SPX’s $216 earnings power based on actual trailing quarterly results. As of the end of June that’s been reduced to $222/share, only 2.8% above $216 earnings. But still positive growth.
We’re looking for levels we could get to based on investors’ interpretation of value and richness, of earnings power, and what kind of multiples they’re going to put on various scenarios.
Since 2012, SPX bottomed at 14x (trailing 12-month EPS) during the Great Recession, at 16x during the market’s 2018 pullback, and again SPX bottomed at 16x at the brief trough of the 2020 selloff. With the SPX multiple at 17.5x at the close of June, we’re not too far from 16x, which, if we got there, would put SPX at 3456. If we trough at 14x (on earnings of $216) SPX would be at 3,024. This is where you’ve heard a lot of talk about support and potential bottoms.
But those multiples are based on actual trailing 12 months of earnings. If optimistic analysts are right and earnings post gains across Q2 results, markets could bounce, which I’ll get to later.
So-called “standard recessions” see earnings drop from peak to trough on average 26%, though severe recessions see deeper cuts. The Great Recession saw earnings get a 57% haircut. So, analysts typically define the average contraction in earnings during recessions being between 25%-50%.
In the 2000-2002 recession, SPX earnings dropped 39% peak- to- trough. Still, SPX’s bear market lows came after earnings lows, with the SPX, not the Nasdaq Composite, down 50%.
Discounting the current run rate of SPX earnings ($216) by 26% brings them down to $159/year. If earnings fall that much and investors worry the recession could be long-lived, and or inflation persistent and embedded, they could put a 14x multiple on the benchmark – the same as the trough multiple at the Great Recession. I would take SPX down to 2,226, or a whopping 41% lower, on top of the 21% SPX was down at the end of June.
A 16x multiple would see SPX at 2,544, down another 26 percent from June and down 47% from the benchmark’s all-time early January 2022 highs of 4,818.
At a 17.5x multiple on run-rate earnings of $159, SPX would be at 2,782.
At half the average (25%) drop in earnings during standard recessions, a drop of 12.5% in earnings, SPX earnings would be down from $216/share (peak earnings) to $189/share.
Applying a 14x multiple gets SPX to 2,646. A 16x multiple gets the index to 3,024. And a 17.5x multiple gets SPX to 3,307.
With a recession presumably upon us, the best case for the least drop-off in earnings at the average 10-year PE multiple (17.5x) still sees the S&P 500 down another 12% from June’s 21% drop from its highs.
With nothing but growth projected for Big Tech, if they disappoint this quarter, and worse, guide down in their analyst and investor calls, they all could go lower…
E specially in a rising rate environment.
That’s what I’m seeing and betting on, sorry to say – a falloff in profit margins and earnings, and further downside in the market.
My levels for the S&P 500 are:
First line of defense support is at 3,650; next support at 3,400; but if we get there, there could be some panic selling down to good support at 3,200.
My worst-case: earnings rout, with investors applying a low multiple on those earnings projection, could see SPX at 2,800.
Look out below.