August 1, 2022
Strong Hands In Market Taking Control Over Weak
We’re not (yet) in a recession. Or if we are, it may be some time before Americans officially know as the nation’s official arbiter of economic cycles, the National Bureau of Economic Research (a private think tank of economists anointed by the U.S. Commerce Department to make such pronouncements), always takes its time delivering its analysis to we, the great unwashed.
To be fair, the eight members of its "Business Cycle Dating Committee" are a secretive and methodical group by design: The idea is to keep them insulated from the intense political pressures that inevitably would bear down on them. To that end, they have declared recessions many months after they have already occurred, making their work, well, moot.
It should also be noted that the NBER looks at data overlooked by the headline writers who declare recessions based on two consecutive quarters of declining GDP. NBER’s methodical analysis should be helpful in getting a handle on an economy that’s throwing off mixed economic signals. Though again, a recession may have passed before it officially pulls the fire alarm.
To that end, it has been known since late June that the U.S. economy contracted at an annual pace of 1.6% in the first quarter, while the initial second-quarter slowdown is now estimated at -0.9%. (It’s likely to be revised.) So even if we accept that we’re in a recession, what matters most is how long it lasts and whether or not it will steepen or remain shallow.
Markets So Far Unconcerned
Mindful that recessions often take a heavy toll on individuals and families (a "recession is when your neighbor loses his job ... a depression is when you lose yours," former President Reagan once observed), investors have so far been less concerned about the "R" word and far more focused on second-quarter corporate earnings. That couldn’t have been any more clear in the waning days of July.
In this space last month, I noted that analysts had "overshot" the S&P 500’s projected closing price (through June 23, 2022) by more than 25%. They did so because they initially over-estimated first- and second-quarter earnings growth. Once again, they’re re-adjusting. This time, however, the adjustments are to the upside.
When earnings season started in mid-July with banks announcing that they were setting aside some of their healthy profits to offset future loan defaults, market indexes slumped. At about the same time, retailers like Walmart and Target said their earnings were undermined by a combination of too much inventory and shifting consumer spending. The nice-to-have stuff like bigger TVs and softer towels have been put on hold for essentials like gasoline and food. That’s the effect of 9.1% inflation.
However, Wall Street’s mood quickly turned giddy even as the Conference Board’s leading economic indicators turned negative. The reason: Better-than-expected earnings trumped the rising prospect of a recession that may or may not materialize.
Earnings aggregator FactSet put it this way: "The number of S&P 500 companies reporting positive earnings surprises continued to rise over the past week. As a result, the earnings growth rate for the second quarter is higher today compared to the end of last week and compared to the end of the quarter."
In numerical terms, 73% of reporting companies (more than half of the S&P 500) have delighted investors with earnings-per-share results topping estimates. That’s up from 68% the week before.
Sector-wise, more than 80% of companies in health care, consumer staples, technology, energy, materials and even utilities have so far topped second-quarter earnings. Conversely, some of the biggest "misses" have been reported by financials (37%) and communication services (50%).
There are, of course, some important caveats to consider in all these earnings surprises.
The first is this: While 73% is a strong positive earnings surprise figure, it is below the five-year average of 77%. And while third-quarter guidance has so far been decidedly upbeat, 9.1% inflation coupled with falling home prices and sagging consumer confidence could sabotage third-quarter profits.
And here’s one more thing worth considering. Not surprisingly, 78% of energy companies have so far beaten second-quarter earnings estimates. (After all, oil prices are up 30% this year while natural gas prices have soared over 130%!) Strip out that sector’s earnings growth and things are less rosy. At this time, third-quarter earnings growth for the S&P 500 is forecast to be 6.0%. If that’s the case, it would mark the slowest pace since the fourth quarter of 2020 (which captured the full effects of the pandemic’s economic slowdown).
Action Recommendation: So what was July’s rebound all about? In part, longer-term investors picking through the rubble of a market that had lost about 20-30% of its value this year, but whose underlying corporate earnings didn’t warrant such a hefty discount.
July was not a signal to re-enter the market with abandon. But it was a good reminder that, from time to time, stocks and entire sectors do go on sale.— John Bonnanzio