October 1, 2022
Darkest Before Dawn?
Earnings Season Is Key
Below is a chart that needs no explanation: it’s the year-to-date returns of Fidelity funds by asset class. And, yes, it’s likely the worst nine-month performance graph we’ve produced in 20 years.
With the exception of Global Commodity Stock (which is mostly comprised of agricultural, energy and metal investments), everything else is in negative territory. Even Telecom & Utilities, which is arguably a defensive sector fund and has held up relatively well, slipped from barely positive territory at the end of the second quarter to down 4.3% by the end of the third. Likewise, sectors whose earnings tend to be stable in a weakening economy have also been punished. For example, Consumer Staples (down 13.2%), Health Care (down 18.0%) and Telecommunications (down 24.4%) have hardly been safe harbors. And neither has Select Gold. Down 27.8% this year, the fund (whose performance is leveraged to the metal) has fared much worse than bullion itself (down 8.9%).
So, with all due respect (and empathy) to our readers who have been in Hurricane Ian’s path, the question we all face now is this: Have we experienced the worst of the stock-market selloff, or are we merely in the storm’s eye with more pain to follow?
Let’s deal with the most worrisome possibilities first.
Apart from Russian militarism making a global recession the least of everyone’s problems, there’s the little matter of corporate earnings.
Anecdotally, many companies have been able to buck the tide of two (and perhaps three) quarters of declining GDP growth by simply raising prices. Consumers have so far shown the ability to manage 8%-plus inflation thanks to wage gains, shifting spending habits, and by spending down their Covid-era savings. Of course, there are limits to each of these strategies. Notably, there are signs that consumer spending has been sustained owing to something more worrisome: greater credit card use.
On that score, using one’s "plastic" to meet rising prices has become more dangerous because of higher borrowing costs. Most obviously, the Fed’s aggressive tightening has started to impact the all-important housing and construction market. With conventional mortgage interest rates now about double where they had been at the start of the year, home prices have started to slip, and actual sales of existing homes are falling. That’s not just bad news for sellers and builders, it’s potentially unwelcome news for box stores like Lowe’s and Home Depot, as well as the companies that make and sell everything from garden gnomes to furniture, drapes, and home appliances. Claims the National Assn. of Realtors, "every home sale adds more than $88,000 to the economy."
With that in mind, corporate earnings managed to grow during the first two quarters of 2022 even as the economy modestly contracted. Unfortunately, the third quarter may be shaping up to disappoint Wall Street.
Negative Earnings Revisions
According to earnings aggregator FactSet, the third quarter may see "the largest cuts to earnings-per-share estimates for S&P 500 companies" in more than two years.
Now that sounds worse than it is because two years ago the U.S. economy was collapsing under the weight of a pandemic. In terms of actual projections, it sees Q3 earnings growing at a rate of 2.9%. If that holds, it will be its slowest rate since Q3 2020. However, earnings fell 5.7% in that period, and there’s little chance of that happening this time around.
Still, Wall Street analysts have been lowering their Q3 earnings estimates which, on the one hand decreases the odds of more disappointments, but on the other hand may signal trouble, too. With earnings season starting in mid-October with JP Morgan Chase and other national banks at bat, they may be harbingers of what’s yet to come.
Again, there will be some earnings growth. But as consumers and businesses struggle against the tide of rising prices (and in the case of businesses, rising wages and commodity prices), the real challenge may be the outlook for Q4 earnings.
So here’s the silver lining: With share prices down considerably, valuations such as price-to-earnings are more attractive now than they have been in many years. While that may not be helpful in the short term, the foundation has been laid for the next big buying opportunity.— John Bonnanzio