If the pandemic has taught us anything I think it is that this economic cycle is unlike any others we can point to in history given the uniqueness of how the entire globe has had to react to Covid-19. The investment community tends to try and predict current trajectories with those of prior cycles, and I am no different. In fact, in my latest quarterly letter to clients I pointed out that during the last four recessions S&P companies saw profits fall between 20% and 40% peak to trough. Coupled with near-certain multiple compression, it is easy to see how and why stock prices get walloped during recessionary periods, even if the drops are relatively short-lived in the grand scheme of things.
So here is where I am going to through a wrinkle into the discussion. What if things play out a little bit different this time? I doubt we can avoid a recession at this point, given that Q1 GDP was negative (due solely to a lack of exports by the way - entirely pandemic related). Q2 GDP could easily put us into a recession. In fact, the Atlanta Fed’s real time estimate for Q2 is currently showing a negative reading, so that ship might have sailed already. So what would be different this time? Well, what if corporate profits hold up better than in recent prior cycles, which could serve to cushion the downturn in stock prices a bit and help spring a fairly quick recovery?
There are a few factors that I think could play into this thesis. First, Q1 earnings actually rose year over year despite negative GDP growth. Current forecasts call for another (small) increase for Q2 despite a possible negative GDP print. So that’s interesting. Even if second half 2022 profits fall versus 2021, it would take quite a big impact to see the typical 20-40% decline from 2021’s record profit level.
There are multiple tailwinds to earnings this cycle that have not been big factors in recent decades. Strong energy prices relative to what we would normally see in a recession? Check. High inflation that keeps revenue figures elevated as long as customers don’t balk at buying? Check. Interest rates that are rising rather than falling, which would actually help the bottom lines of many financial companies? Check. A historically tight labor market that might result in the unemployment rate rising less during this downturn that prior ones? Check. Relatively limited supply of housing units relative to demand that could limit any glut/price collapse for both owned and rented properties? Check.
Look, this is just a thesis that seems like it has a bunch of bullet points going for it. I have no idea if we actually see corporate profits only decline 10 or 15% this cycle versus 20-40% historically. But if one is feeling a tad more bullish than many headlines would indicate, there are green shoots to point to.
I also wonder if this is why the P/E for the U.S. stock market remains near historical averages for a mid-cycle climate (16-17x) rather than a recession (10-14x). If a recession comes but profits hang in there, there might not be a reason for stocks to ever trade that low. So maybe the market is expecting profits to hold up rather well, just as I am postulating. Of course, the flip side of the argument is not reassuring (i.e. if this thesis is wrong maybe another big leg down is coming).
Needless to say, I am more interested in watching profit numbers than I am GDP or CPI going forward. While I agree estimates need to come down from current levels, I want to see by how much. I think that will tell us whether the worst for the market is behind us, or if 2022-2023 is going to play out similarly to 2001/2008/2020.
For those who will be doing the same, here is where the numbers stand as of today for S&P profits:
2021 CY: $208 (all-time record, 32% above 2019’s $157)
TTM Q1: $210 (+40% yoy)
2022 Q1: $49 (+4% yoy)
2022 Q2: $55 (estimate, +5% yoy)
2022 CY: $223 (estimate, +7% yoy)