Stocks court nasty earnings surprise

Wall Street analysts have cut their overly optimistic earnings estimates slightly in recent months, but they are still far from acknowledging the threat of a recession. This makes the market particularly vulnerable if other companies follow FedEx Corp’s decision. to withdraw its earnings forecasts by lowering their own outlook.

FedEx’s Thursday night move sent its shares tumbling the most since 1980 and came amid a growing disconnect between the macro outlook and analysts’ earnings projections, which are largely driven by indices that businesses provide on their future.

The median economist(1) surveyed by Bloomberg now gives an equal probability that the United States will experience a recession in the next 12 months, compared to a probability of around 33% at mid-year. Economists worry that the Federal Reserve’s efforts to contain the worst episode of inflation in 40 years will ultimately come at the expense of the labor market and resilient consumer trends. The hard data suggests the economy hasn’t deteriorated yet, but history suggests it will eventually, and equities are unlikely to be immune.

Since 1960, the average decline in income from peak to trough during a recession is around 31%, according to data from Professor Robert Shiller of Yale University. Yet stock analysts on the sell side aren’t even close to pricing in such a drop. In fact, estimates for 2022 and 2023 still imply that rolling 12-month earnings will maintain their steady upward slope, implying something close to an optimal scenario.

It’s not just analysts who are optimistic, however; markets appear to be buying that optimism to a large extent, even after factoring in the S&P 500’s 4.8% drop last week. The S&P 500 earnings yield – the ratio of expected EPS to price, or the inverse of the P/E ratio – continued to trail Treasury yields throughout the year, indicating that it is the latter that really drives the market.

At some point, the focus will necessarily be on profits, but that transition has yet to happen. If markets actively questioned earnings prospects or generally priced in more risk in equities, this would translate into a wider spread between earnings yield and Treasuries. On the rare occasions when earnings yields have broken from 10-year Treasury yields, it’s often because traders have applied a more bullish bias to equities.

So why do investors seem content to remain so optimistic about earnings despite all the apparent headwinds? First, market participants may have reason to doubt that the 50% probabilities of a recession are correct. The resilience of earnings and macro data so far this year has bolstered belief that this rate hike cycle will be unlike most others and that the Fed will make the elusive “soft landing”. The unemployment rate remains close to its historical lows; household debt ratios remain very low; and retail sales are mostly buzzing, at least nominally. Many traders may find it difficult to reconcile the pessimism of economists with the facts on the ground. It may take a clear turn in the hard data to change your mind. Alternatively, a series of companies abandoning or revising downward their earnings forecasts could do the trick.

Second, not all recessions are catastrophic. Although an average recession zaps 31% of EPS, the average is weighed down by the dot-com meltdown and the financial crisis, as my Bloomberg Intelligence colleagues Gina Martin Adams and Gillian Wolff recently noted in their research. Given the many financial advantages households have for weathering a downturn, traders may believe that any recession and subsequent earnings dip would be shallower than recent ones – and perhaps more like the downturns of the 1960s, 1970s. and 1980. Of course, investors have to be careful what they wish for: the 70s and 80s may have had less deep recessions, but recessions were also more frequent.

Even if you split the difference between the moderately optimistic and the moderately pessimistic – 50% chance of Wall Street’s status quo with ho-hum earnings growth, 50% chance of mild recession – a probability-weighted approach would have traders betting on single-digit earnings decline over the next 12 months, but the market isn’t there yet. Historically, recessions have also coincided with P/E multiples below the current 16.5 times. But even if you are somewhat generous with the multiple, it is clear that market prices are still on the bullish side of the earnings close. As the following chart shows, there are many paths for the S&P 500 to clear the June low of 3,667, and likely fewer paths up.

The FedEx news has the market on edge ahead of the Fed’s next monetary policy decision on Wednesday, in which policymakers are expected to raise the upper limit on the federal funds rate by 75 basis points to 3.25%. Despite all the strength in the economy, the so-called “long and variable lags” in monetary policy are likely to play out at some point, and the stock market appears ill-prepared for what’s to come. None of this means the US is headed for some sort of 2008-style earnings calamity, but you don’t have to believe that to recognize that the market seems overly bullish. The development of FedEx may well be the first in a series of catalysts that help merchants realize this.

More other writers at Bloomberg Opinion:

• Wall Street is in denial of the “real” economy: Gary Shilling

• Your Guide to the Permanent Pandemic Economy: Allison Schrager

• The rate shock of 2023 may lie in its normality: Daniel Moss

(1) Economists as a group have a poor track record of predicting recessions, but that’s usually because they’re too conservative. Very rarely do they forecast those that won’t happen, as an IMF working paper revealed.

This column does not necessarily reflect the opinion of the Editorial Board or of Bloomberg LP and its owners.

Jonathan Levin has worked as a Bloomberg reporter in Latin America and the United States, covering finance, markets, and mergers and acquisitions. Most recently, he served as the company’s Miami office manager. He holds the CFA charter.

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Garland K. Long