This time, it’s real. The corporate earnings recession, that is. For the better part of six months now, markets pundits have been muttering away about a lack of growth in corporate profits. Without that, the classic theory goes, you just can’t have other good things, like economic growth, job growth and stock market growth.
The problem – until now – is that most of those analysts have been looking at the corporate earnings picture too broadly. That’s why the economy has kept growing (however anemically) and employers have continued to add jobs (just not at the impressive pace that we all might like to see), and why the stock market has at times been able to shrug off its malaise and trade in positive territory this year, leaving stocks at relatively high valuations.
So far, they’ve been looking at the overall declines in profitability for companies in the Standard & Poor’s 500 index – the headline figure – and ignoring the fact that if you stripped out the results for energy, profits have continued to grow. Energy companies make up only about 6% of the S&P 500, but their outsize losses as crude oil prices have plunged since late 2014 have had a disproportionately large impact on those headline results: for instance, in the fourth quarter, all S&P 500 companies reported that profits fell 2.9%. Removing the results of the handful of energy companies, however, and you were left with a 3.4% gain.
That’s still not a great number, but it does mean that 94% of the companies in the index were, collectively, still posting positive results. A profits recession, to me, at least, is something that afflicts a broad cross-section of the economy, not simply a single sector that has been hammered by a single factor: the decline in price of a commodity.
In other words, a profits recession is what we could be about to confront in the earnings season that has just begun.
This time around, says Greg Harrison, a senior research analyst at Thomson Reuters, only a handful of the sectors within the S&P 500 won’t suffer from declining profits – healthcare, telecommunications, and a catch-all category dubbed “consumer discretionary”, which includes retailers, media companies, and auto makers. The rest? It’s going to be a sea of red ink.
Harrison, whose job is to track analysts’ earnings forecasts for individual companies, quarter by quarter, and transform these into estimates for how much growth in profits those businesses in the S&P 500 index will witness, is predicting that this quarter will see a 7.8% decline in profits overall, including energy stocks. Remove those from the equation, and earnings will still fall 2.1%.
To have an economic recession, the rule of thumb is that we need to have three successive quarters during which gross domestic product, or GDP, falls – not just that it’s growing at a slower rate, but that it actually is contracting. If you want to include the wild card of energy prices, this would be that magic quarter that unquestionably does put us into a profits recession.
Some argue that it doesn’t make sense to look at corporate earnings excluding energy, since the losses on one side are compensated for by gains in other sectors, helped by lower crude costs. In actuality, retailers have griped that they haven’t benefited from lower crude prices; some economists have hypothesized that a lack of wage growth ensures that consumers prefer to hang on to their savings. Moody’s Investors Service has calculated that even packaged foods, one of the industries most affected by fuel costs, has saved about 10%. Overall, the impact of lower oil prices is already dwindling, Moody’s added.
So, should the declining earnings picture cause you to panic?
If the market’s rollercoaster ride this year hasn’t driven you to the brink of insanity, then congratulations. There is no reason to subscribe to any of the theories asserting that simply because, in the past, profit recessions have been followed by economic recessions, that must necessarily be true this time. Ask any historian: deterministic thinking is flawed.
That isn’t to suggest that there aren’t risks – or that the outlook is rosy.
“We live in a low-growth world,” says David Lafferty, global market strategist at Natixis Global Asset Management. Because corporations weren’t producing much in the way of earnings growth in the first place – and because revenue growth wasn’t so rosy, either – that collapse in the price of crude oil and the slump in energy-company profits were able to cause the damage they did to S&P 500 profits, he says.
Lafferty isn’t predicting that the dismal second-quarter earnings numbers are the harbinger of an economic apocalypse, or even of a stock market selloff. He just warns that investors shouldn’t expect either companies or financial markets to work miracles, either, in the absence of some help from the broader global economy. And there isn’t much sign of that on the horizon.
Indeed, earlier this week, the International Monetary Fund again trimmed its forecast for global growth by 0.2 percentage points to a mere 3.2%. That still keeps it above the 3% level that the organization considers to be a technical recession, and ahead of last year’s 3.1% pace – but with less room for error. And the IMF’s chief economist warned of a global economy reaching “stalling speed” and raised concerns over the quality of what growth does materialize.
That said, one of the main headwinds to US corporate profits – falling oil prices – will stop being an obstacle, at least on a comparative basis, starting in the second half of this year. We’ll have one more quarter of grim earnings results to get through. Although right now analysts still predict that, ex energy, the S&P 500 companies will post higher profits in the second quarter, Harrison says he expects that to change by the time they actually start reporting their results, based on the rate at which they are already cutting their estimates. After that, however, “the energy effect fades into the past,” says Lafferty.
And that means that we’re heading toward what Lafferty calls “the new normal, or secular stagnation”. Corporate earnings might resume growing, but at no more than a rate of 3%, 4% or 5%.
Stocks are valued based on their earnings – that’s where that price/earnings ratio comes from. So a stock’s price can grow based on one of two factors: in response to a growth in earnings, or because investors feel that each dollar of earnings is somehow worth more. The same is true for a stock market index. Lafferty calculates that half of the S&P 500’s growth has come from growth in earnings, and the other half has come from an expansion in the price/earnings (P/E) ratio, or because investors are putting a higher value on every dollar of profits.
That latter source isn’t sustainable, he argues. “We’re in the 75th percentile [of the P/E ratio]; stocks have been more expensive than this only 25% of the time.” That doesn’t mean that stocks are overvalued right now, but further big gains would push them into that territory and make them vulnerable to a big selloff. What you can expect is that the only source of future stock price gains are earnings increases, and those are going be downright unimpressive. “We are just slogging through.”
Don’t hit the red panic button and bail out, in fear of a major recession. There are no signs that this is on the horizon. Instead, what is awaiting us all is something quite different, and worrying in quite a different way.
This first quarter of widespread negative profits signals that the seven-year-old bull market is going to stop dead in its tracks, felled by a complete lack of momentum. It might not collapse, and turn into a rout. But even when earnings return this autumn, don’t expect the ageing bull to shake itself back to life.
