Inflection Points and Earnings Pessimism

We talk a lot about bear markets sowing pessimism—and that pessimism building the next bull market’s wall of worry. Inevitably it risks becoming cliché. But then a concrete example comes along. Like this one: Last summer, when stocks first reached bear market territory, pundits everywhere said analysts needed to slash earnings expectations before stocks could bottom and a recovery could begin. Only that would show they had brought expectations back in line with reality, purging their supposedly irrational optimism. Well, they have done that. Expectations for Q4 S&P 500 earnings have plunged from 4.8% y/y growth in late September to a -4.9% decline now, as earnings season dawns.^[i] That is one of the biggest swings on record. Yet now people say even this is too optimistic, and analysts must pencil in more red ink to ensure troubles are fully baked in. This, folks, is the “pessimism of disbelief” that underpins new bull markets.

That term, coined by Fisher Investments Founder and Executive Chairman Ken Fisher, refers to investors’ general tendency to ignore or pooh-pooh any remotely good news late in a bear market (and early in a new bull market), seeing only gathering storms ahead. You can see it when there is just no pleasing people, like when good economic news means only that the Fed might keep hiking rates. Dismissing the drop in earnings expectations as not deep enough is adjacent to this. Ordinarily, such a big swing in projections would cause some gasps. And now it isn’t big enough? Seems to us like a fun-house-mirror view of the world.

At the same time, maybe -4.9% y/y isn’t as bad as it will get for S&P 500 earnings. Perhaps the final tally, once all companies have reported, will miss those expectations. That would be unusual, though, given analysts are routinely too dour. As FactSet recently noted, total S&P 500 earnings beat expectations in 38 of the past 40 quarters, with Q1 2020 and Q3 2022 the lone exceptions.^[ii] But it is possible. So are further declines. Analysts presently expect Q1 2023 earnings to drop -0.6% y/y and Q2 -0.7%. Those, too, are big swings from the 9.6% y/y Q1 growth and 10.3% Q2 growth analysts penciled in last June.^[iii] Forecasts could get lower still, and they could prove correct.

But here is the thing: Stocks move far in advance of earnings. Bear markets typically begin well before earnings start declining—and well before those declines are known, given the lag between quarter-end and earnings reports. At the other end, bull markets begin before earnings start bouncing. For an extreme example, consider the bear market that accompanied 2007 – 2009’s global financial crisis. Then, stocks bottomed—and a new bull market began—on March 9, 2009. S&P 500 earnings kept tanking: They dropped -26.8% y/y in Q2 2009 and -15.7% in Q3.^[iv] Earnings soared in Q4, more than doubling year-over-year, but it had much more to do with cost cuts and a low base effect from Q4 2008 than a rip-roaring recovery, as sales rose just 5.2%.^[v] At the time, most still expected a double-dip recession and more carnage ahead. But the S&P 500 looked past all the bad news and gloom, rising 67.8% from March 9 through yearend, gains that compounded over the bull market’s succeeding 10-ish years.^[vi]

More recently, in 2020’s lockdown-induced bear market and recession, stocks bottomed on March 23. S&P 500 earnings dropped that quarter. Then again in Q2, down -31.6% y/y.^[vii]  And yet again that Q3, albeit with a milder -5.7% decline, before modest recovery began in Q4 2020.^[viii] But here, too, stocks didn’t mind that earnings kept falling: The S&P 500 soared 70.2% from March 23 through 2020’s end.^[ix]

Now, these dates are all coincidental—we aren’t saying stocks bottom in March and earnings bounce the following Q4. That is mere happenstance. We think the general principle is what matters: Stocks pre-price the economic improvement that breeds the eventual earnings recovery. This is part and parcel of efficient markets. Stocks price in widely known information and probable happenings over the next 3 – 30 months. A new bull market doesn’t require actual improvement in earnings and economic data. A high likelihood of that improvement occurring within the foreseeable future is generally good enough.

Perhaps stocks have been seeing that since October 12, the most recent low. It wouldn’t be the first time a bear market had ended before an earnings drop or recession (should we get one) became official. Those who argue earnings need to cycle all the way through the bad times before a recovery becomes legit make the fundamental error of presuming there is such a thing as an all-clear signal. There isn’t. The maddening thing about capturing early bull market returns means you generally need to be invested when backward-looking data look ugliest.

Not that we are saying the bottom is for sure in. That is unknowable now. It could be, or the past few months could be a bear market rally before a last leg down. Either way, we suggest not looking to the immediate future but to the next 3 – 30 months. However earnings do immediately ahead, stocks should have a nice earnings recovery to price within that window.