The Earnings Recession Does Not Bode Well

Eric Parnell, CFA |

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Since mid-July, the S&P 500 has surged over +15%. Is the worst of the 2022 stock market decline now behind us? Entering 2022 Q2 earnings season on June 30, the S&P 500 was projected to post quarterly GAAP earnings per share of $51.61 per share, which represented a respectable year-over-year increase of more than +6%. But with more than 90% of 2022 Q2 earnings having now been reported, quarterly GAAP earnings per share ended up a significant lower at $42.53 per share, which is -18% lower than initial expectations at the end of June (yet 75% of companies that reported earnings managed to “beat” analysts’ estimates – how does it make any sense?). Estimates for 2022 Q3 GAAP earnings were also slashed by -12%. This meaningful decline in forward “E” coupled with the sharp pick up in the S&P 500 “P” have suddenly returned stocks to a much more expensive 22 times earnings. Inflation expectations have also settled into a higher range. After peaking in late March and early April, inflation expectations as measured by the 5-Year and 10-Year breakeven rates had been steadily falling for months. But in recent weeks, these readings have steadied at a measurably higher level versus what we have seen for many years. The S&P 500 has now arrived at its downward sloping trendline resistance dating back to the start of 2022. It just so happens that this level coincides almost exactly to the S&P 500’s now downward sloping 200-day moving average resistance. This convergence is taking place at the same time that the Relative Strength Index (RSI) on the S&P 500 has moved meaningfully above a reading of 70, which represents an overbought reading for stocks. In other words, stocks have risen very far, very fast and may need to cool off a bit with a pullback. While short-term interest rates are certainly rising at a blistering pace in many parts of the world including the U.S, another arguably more important factor working against the market today is the increasingly determined shrinking of central bank balance sheets worldwide. While the U.S. Federal Reserve’s balance sheet has still held relatively steady having only shrunk by less than $90 billion since early April, major central banks from around the world have been offloading their balance sheets far more assertively. For example, both the European Central Bank and the Bank of Japan have decreased the sizes of their balance sheets by roughly $1 trillion or more since the start of the year with further declines to continue. The same can be said of the People’s Bank of China, which has also contracted its balance sheet by more than $500 billion. Why does this matter? Because central bank asset purchases were the lifeblood that helped propel stocks into the stratosphere for so many years during the post-GFC period despite otherwise lackluster economic growth prospects. And nowhere in the world was this truer than the U.S. stock market. Thus, if what was once a critical tailwind when the central banks were expanding their balance sheets logically becomes a meaningful headwind now that central banks are shrinking their balance sheets back down. Given the underlying forces currently at work, a U.S. stock market decline back below the June lows should not be ruled out between now and Thanksgiving Day.