The median (1) economist polled by Bloomberg now gives the odds that the US will even suffer a recession in the next 12 months, up from a 33% chance in the middle of the year. Economists worry that the Fed’s efforts to rein in the worst bout of inflation in 40 years will eventually come at the expense of labor market and resilient consumption trends. The hard data suggests that the economy hasn’t bottomed out yet, but history suggests that it will eventually come to an end, and there is little chance that stocks will be immune.
Since 1960, average peak-to-trough incomes in the recession have fallen by about 31%, based on data from Yale University professor Robert Shiller. However, sell-side equity analysts aren’t even close to incorporating such a dip. In fact, estimates for both 2022 and 2023 still suggest that 12-month rolling earnings will maintain their steady upward slope, indicating something close to a best-case scenario.
But analysts are not the only optimists. Markets seem largely to buy into this optimism, even after accounting for last week’s 4.8% decline in the S&P 500. The S&P 500 earnings yield – the ratio of expected EPS to price, or the inverse of the price-to-earnings ratio – has continued to track Treasury yields on the Throughout the year, which indicates that it is the latter who really leads the market.
At some point, the focus will necessarily shift to profits, but that transition has not yet occurred. If the markets actively question earnings expectations or generally expect more risk in stocks, this will be reflected in a broader dividend yield – the treasury spread. On the few occasions that dividend yields have broken their stride with 10-year Treasury yields, it is often because traders have used more bullish bias on stocks.
So why do investors seem content to remain optimistic about earnings despite all the obvious headwinds? First, market participants may have reason to doubt the validity of the fifty percent odds of a recession. The elasticity of earnings and macroeconomic data so far this year has reinforced the belief that this rate increase cycle will be different from most others and that the Fed will make the “easy landing” out of reach. The unemployment rate remains close to an all-time low; Family influence rates remain very low; And retail sales mostly, at least nominally. Many traders may find it difficult to reconcile the pessimism of economists with the facts on the ground. It may take an obvious turn in the hard data to change their minds. Alternatively, a series of companies abandoning or retracting their earnings expectations may hit the target.
Second, not all recessions are catastrophic. Although the average recession drops 31% of EPS, the average is affected by the Internet crash and the financial crisis, as Bloomberg Intelligence colleagues Gina Martin Adams and Gillian Wolfe recently noted in their paper. Given the many financial advantages that households have to assume in an economic downturn, traders might think that any recession and the subsequent decline in earnings would be less shallow than the last recession—perhaps more like the downturns of the 1960s, 1970s, and 1980s. Of course, investors should pay attention to what they wish for: the 1970s and 1980s may have seen less severe recessions, but recessions were also more frequent.
Even if you split the difference between moderate optimism and somewhat pessimistic — 50% odds of the status quo on Wall Street with earnings growth, and 50% of a mild recession — the probability-weighted approach would have traders bet on one individual. The earnings figures are dropping in the next 12 months, but the market is not there yet. Historically, recessions have also coincided with introduced P/E multiples below the current 16.5 times. But even if you’re somewhat generous with the complications, it’s clear that market prices are still on the optimistic side of the earnings fence. As the following table shows, there are plenty of paths for the S&P 500 to break through the June low at 3667, and possibly higher lower paths.
FedEx news has the market on edge heading into the Federal Reserve’s upcoming monetary policy decision on Wednesday, as policy makers are expected to raise the upper bound on the federal funds rate by 75 basis points to 3.25%. Despite all the strength in the economy, the famous “long and variable lags” of monetary policy are likely to be affected sometime soon, and the stock market appears unprepared for what’s to come. None of that means the US is headed for some sort of 2008-style earnings disaster, but you don’t have to believe it to admit that the market looks overly optimistic. The development of FedEx may be the first in a series of catalysts that help traders realize this.
More other writers at Bloomberg Opinion:
Wall Street in denial about the “real” economy: Gary Schilling
Your Guide to Perpetual Epidemic Economics: Alison Schrager
The 2023 rate shock may lie in its nature: Daniel Moss
(1) Economists as a group have a poor track record of anticipating recessions, but this is usually because they are very conservative. They rarely anticipate the ones that haven’t materialized, an IMF working paper found.
This column does not necessarily reflect the opinion of the editorial staff or Bloomberg LP and its owners.
Jonathan Levine has worked as a journalist at Bloomberg in Latin America and the United States, covering finances, markets, and mergers and acquisitions. Most recently, he held the position of Head of the Company’s Miami office. He is a chartered CFA.
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