This Earnings Season Could Crush Your Portfolio… Unless You Do This Now
Shah Gilani|April 21, 2023
We’re not in an economic recession, at least not yet, but it sure looks like we’re entering an earnings recession.
The only reason stocks have held up so far despite falling EPS (earnings per share) is that a lot of traders, investors, and analysts think the Fed’s going to pause their rate hiking regime, if not at the upcoming May FOMC meeting, then right after they hike one more time. And optimistic punters believe the Fed will start cutting rates in the second half of the year, so they’re “frontrunning” rate cuts by buying stocks now.
But, if you’ve been reading my stuff for a while, you know why that mindset is crazy. The Fed will only start cutting rates if inflation magically falls to below 2% or the economy crashes into a “hard landing” recession.
That first scenario isn’t likely to happen anytime soon. And the problem with the second scenario is that by the time we recognize that it’s happened, it’ll already be too late for markets.
And it gets worse, because when an earnings recession and an economic recession dovetail, the results have historically been catastrophic.
I hate to break it to you, but we’re on the verge of seeing that right now, with an earnings recession that could help push the economy into a real recession.
If it happens, stocks will get absolutely crushed. I’m talking “run over by a train” levels of crushed.
But you know what I always say: there’s a way to make money in any market, up or down. So you don’t have to stand in front of that oncoming train. There’s a lot you can do to bob, weave, and make a ton of money on what you know is coming.
Let me show you what to look for – it’s a lot of math, but stick with it – and how to play it.
What’s Been Happening with Earnings, and How We Got Here
My friend Charles Payne, host of Fox Business News’ show Making Money, always says, “Earnings are the mother’s milk of stock market investing.” I wholeheartedly agree with him.
If you don’t agree, I’ll grant you that over shorter time horizons – days, weeks, sometimes months – lots of narratives and news can move individual stocks and markets, both up and down. But when the dust settles, it always comes back down to earnings.
When it comes to “the market,” the most common earnings measure is what stocks in the S&P 500 are earning collectively. If you add up what every stock in the S&P 500 earns per share, in a quarter or in a year, and divide that total by 500 you get the S&P 500’s quarterly or yearly EPS, earnings per share.
For a little over a decade, earnings have been in a constant swing, from recovery, to growth, and back down again.
For the quarter ending September 30, 2010, coming out of the frightening 2007-2009 financial crisis and Great Recession, S&P 500 quarterly earnings per share were $19.52. The following quarter ending December 31, 2010, EPS posted an almost 6% consecutive quarter increase to $20.67.
EPS on the benchmark index didn’t get out of the twenties until the quarter ending March 31, 2018, nine years after the stock market bottomed in March 2009, when EPS came in at $33.02, a whopping 22.4% increase over prior quarter December 2017’s EPS posting of $26.96.
From the quarter ending March 2018 through the quarter ending December 31, 2019, S&P quarterly EPS averaged $34 per share per quarter. Still on the way up.
But then, the pandemic struck. EPS for the quarter ending March 31, 2020 plummeted 66.5% to $11.88 per share from the just prior December 31, 2019 quarterly print of $35.53 per share.
Fortunately, earnings rebounded spectacularly off the March 2020 lows. The June quarter 2020 EPS number was $17.83, September jumped to $32.98. March 2021, a year after the Pandemic destroyed earnings, EPS skyrocketed up to $45.95. They got as high as $53.94 for the quarter ending December 31, 2021.
But now, we’re in another downswing.
Subsequent quarters saw EPS dip, spot higher, dip, spot higher, and drop from $44.41 from the third quarter of 2022, to $39.61 for the final quarter of 2022, which is down from $53.94 a year ago. That’s down 10.81% from the last quarter and down 26.57% from one year ago, according to FactSet.
Now, Q1 2023 earnings are rolling out and analysts’ consensus estimates are for them to fall further, maybe by as much as 7% from a year ago.
If EPS comes in below $39.61 for Q1 2023 it would mark two consecutive quarters that earnings per share are falling. They’re not negative – that would mean the world’s gone to somewhere we don’t want to imagine – but two consecutive quarters with falling EPS is an earnings recession in my book.
And that’s not considering what analysts are saying about Q2 2023 earnings, but it’s not good.
How a Recession Could Make Things Much Worse
On top of an earnings recession, imagine an economic recession and what that might do to earnings. Actually, you don’t have to imagine it; I’m going to tell you.
There have been 12 post World-War II recessions, not including the pandemic recession, which I consider to be an anomaly.
For you fellow quant and data nerds out there, those recessions started and ended and had earnings declines from start to end as follows:
- February 1945 -October 1945; ESP -29.4%.
- November 1948- October 1949; – 3.3%.
- July 1953 – May 1954; -17.6%.
- August 1957 – April 1958; -22%.
- April 1960 – February 1961; – 11.7%.
- December 1969 – November 1970; – 12.9%.
- November 1973 – March 1975; -14.8%.
- January 1980 – July 1980; – 4.6%.
- July 1981 – November 1982; – 19.1%.
- July 1990 – March 1991; – 36.7%.
- March 2001 – November 2001; -54%.
- December 2007 – June 2009; – 91.9%.
The average duration of those recessions was 11 months and the average decline in EPS was -26.5%. The median duration was 10 months, and the median EPS decline was -18.4%. Keep these figures in mind; we’re going to use them later.
So you can see that these two things are highly correlated, and you can see that if the economy falls into a recession, the market’s already falling EPS could decline about another 18% to 26%.
Now for the final piece of the puzzle: what the impact on stocks and market valuation metrics would be if this happens.
This Is Why Falling EPS Will Crush the Stock Market
The market gets valued through the prism or earnings, most commonly by a measure called PE, which is a simple equation: price divided by earnings.
Right now, the S&P 500 is at 4150. If you divide that price level by the annual earnings of all the companies (per share), using an annualized number of $187 (December 2021 -December 2022, averaged) the PE on the S&P would be 22. In other words, at 4150, where we are right now, the stock market is trading at 22 times earnings.
Let’s assume, just for argument’s sake, that Q1 2023 EPS is going to stay the same as Q4 2022, and we’ll see what happens to the value of the market if a recession hits.
Q4 2022 earnings were $39.61, so if Q1 2023 EPS comes in exactly the same, at $39.61, and you annualize those two over four quarters, you get a figure of $158.44, and the PE on the S&P right now would be 26.26.
Now let’s apply the potential impact of a recession and see what happens. If you take that annualized figure and haircut it by the median EPS decline over the past 12 recessions, 18.48%, you’d get annualized EPS of $129.16, for a PE today of 32. If you take the average decline in EPS over those 12 recessions, 26.5%, earnings could get down to $116.45, which at 4150 would be a PE of 35.
The market would be considered way overvalued at that point, and analysts and investors would respond accordingly. Historically, from 1900 to 1980, the S&P 500 PE averaged 13.34. From 1980 to 2000, it averaged 15.6. From 2000 to 2022, it averaged 20.2.
So let’s suppose that market valuation would adjust to fall in line with the modern-day average PE. At $129.16, our hypothetical “beaten up by recession” annualized EPS, the S&P 500 would be at 2609.
Do you get that? 2609 versus 4150 today! That means the S&P 500, the market, could drop 1544 points, or 37.2%. If there’s a steeper correction, and PE ends up falling to pre-2000 levels, the S&P would be at 2,014, down 51.10%.
I call that a crash.
Here’s What to Do if the Market Crashes
This scenario isn’t wild speculation. It could happen. If you’re paying attention to the numbers I just put up and how to analyze them, or if you just follow me, you’ll know if it’s happening and see it coming.
If you see it, you’ll want to do four things:
Make sure you have stop-loss orders down on all your stock market positions and trail them up if we get any more “frontrunning” head-fake buying by speculators.
Buy longer dated call options on the CBOE Volatility Index (VIX) to profit from falling stocks and higher fear.
Buy put option spreads on benchmarks like the S&P 500 Index (SPX), SPDR S&P 500 ETF Trust (SPY), and Invesco QQQ Trust Series 1 (QQQ) to rake in profits as markets tumble.
But most importantly, you need to keep following me, because I have the plan. One of my subscription services is designed to target the stocks that get hit hardest by market downturns and play them over and over again. If you wait until the crash is already happening, you could miss out on the best potential opportunity to thrive in a doomed market.