A bad earnings season just might be good for stocks.
Consider this scenario: Companies air their dirty laundry, analysts cut their 2023 outlooks and perhaps the S&P 500 Index takes another detour back toward 3,600. Suddenly, expectations aren’t as hard to beat, and a foundation might be built for a new bull market. Crazy? Maybe just a little.
The past couple of months have bolstered the “soft landing” bulls, who think that the US can defy history and emerge from a fast and furious round of interest-rate increases with inflation curtailed and real output still growing.
Indeed, the latest consumer price index report was so encouraging that it seemed to open the door for the Federal Reserve to stop raising rates after March and maybe even consider cuts in the latter half of the year before the economy goes off a cliff. Improbably, that’s happened with unemployment at a five-decade low and household cash cushions that remain remarkably strong. Clearly, nobody can say for sure whether the progress is durable or how badly the lags in monetary policy will bite in the months ahead. But if there were a path to the soft landing, this is what it would look like.
So what, then, should we make of the coming earnings season?
Quarterly reports are, of course, highly choreographed affairs in which company executives go to great lengths to deliver positive “earnings surprises.” In practice, that usually means telegraphing low expectations so they can comfortably beat them. That they’ve had a harder time of exceeding their own bars is a sign of just how dicey the environment has been and how close the economy has skated to a downturn. The third quarter featured one of the highest rates of negative earnings surprises in the past decade, and investors won’t like it if that happens again.
But mostly, the focus will be on the 12 months ahead, and companies should — and, with all likelihood, will — manage expectations even more aggressively than usual. Since mid-July, analysts have cut 2023 consensus earnings-per-share estimates by nearly 8%, with the lion’s share coming during the two most recent earnings seasons. Each quarter, the cuts have become progressively deeper.
This has not been the typical “window dressing” and has veered toward a wholesale realignment of investors’ understanding of the business atmosphere. Fortunately, it has happened methodically, not all at once. Executives have managed to walk expectations lower without triggering a crisis of confidence of the sort that can itself contribute to the start of a recession.
How much further will management jawbone down expectations this time? If the trend continues, analysts’ downward revisions this quarter should be expected to be even steeper than they have been in the past, translating into consensus 2023 EPS outlook cuts of as much as 5% to $215 by the end of February. Expectations are already within spitting distance of assuming that this will be a down year, and we may get there over the next six weeks.
To be sure, these outlook tweaks will prove much too modest if the US economy is indeed heading toward a recession. Earnings typically fall 20% to 30% from peak to trough in a recession, and the median odds for such a downturn is 65% in the next 12 months, according to economists surveyed by Bloomberg. Another quarter of cuts doesn’t necessarily translate into catharsis and the start of a new bull market, but it’s probably a precondition for one.
Of course, everyone is just making educated guesses about the economy, and all you can do is balance out your risks. A rough stretch of quarterly reports — a “take your medicine” type earnings season — may just establish a more favorable symmetry between the market’s risks and rewards, perhaps encouraging a few brave souls to take a flier on the soft-landing dream. If that’s the case, the feared fourth-quarter earnings season may not ultimately be judged so harshly after all. – Bloomberg Opinion