This market rally is misplaced; good time to sell
While markets are cheering ‘better than feared’ Q2 earnings, a closer look reveals “a very clear pattern of erosion in corporate profits, entirely consistent with a continued slowdown in the economy,” says David Rosenberg’s team. Photo by REUTERS/Kai Pfaffenbach/File Photo By David Rosenberg and Brendan Livingstone
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There has been a lot of optimism in the stock market of late, resulting in a strong rally that was kickstarted by a belief that the second-quarter earnings season was supposedly “better than feared.” And, with 90 per cent of S&P 500 companies reporting results — and 75 per cent have beaten on the bottom line — it is seemingly hard to dispute this notion.
Indeed, this beat rate is remarkably close to its five-year average (77 per cent), which would suggest an average reporting season, alleviating concerns about the impact of a weakening economy on corporate profitability.
But this statistic masks what, in our view, was a pretty soft quarterly performance. Underneath the surface, we believe earnings trends are weakening and are poised to deteriorate further amidst a slowing economy. Against this backdrop, the stock market remains vulnerable, and has yet to put in its ultimate low in this prolonged bear phase.
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For starters, while the 75-per-cent beat rate is about average, the size of these beats has been far less impressive. As per FactSet, in aggregate, earnings have exceeded estimates by 3.4 per cent, which is considerably below the five-year average of 8.8 per cent. As it stands, this would mark the worst “beat” on S&P 500 earnings since Q1 2020 (1.1%).
Earnings momentum is clearly slowing, but this didn’t stop investors from bidding up stocks as speculative fervour regarding the United States Federal Reserve’s “data dependency,” a newfound belief in the economic soft landing and the return of FOMO (fear of missing out) triggered a huge 2.5-point expansion in the market multiple in barely more than a month.
Notably, companies that reported a positive EPS surprise had a positive share price reaction of 2.1 per cent in the days immediately around the release, which is more than double the norm of the past five years (0.8 per cent). But perhaps more remarkably, companies that missed on earnings had an unchanged reaction in their stock price, whereas the average of the past five years has been a decline of 2.4 per cent.
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One of the more notable examples was Amazon.com Inc., which missed on earnings but whose stock price soared nearly 20 per cent between July 26 and Aug. 1 (the company reported on July 28 after hours). One has to ask: were earnings really all that great, or did investors get too negative too quickly and were simply caught wrong footed? The outperformance of the most shorted stocks of late speaks to the latter as the most likely explanation.
Second, while year-over-year earnings trends are still positive, this has been entirely driven by the energy sector. Relative to year-ago levels, Q2 operating earnings are up 1.2 per cent, due to a 340.7 per cent surge in energy. Outside of this one sector, which is just a four-per-cent weight in the S&P 500, earnings growth is running at -10.5 per cent. For reference, this compares to -2.8 per cent year over year in Q1 and 30.2 per cent in Q4 of last year — an unmistakable pattern of erosion.
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Admittedly, part of this slowdown can be attributed to tougher comps (coming out of the pandemic), but it primarily speaks to a deterioration in the economic backdrop, one that has at least partially been obscured by the strength in energy.
Third, since the second-quarter earnings season began in earnest (with the banks reporting results), S&P 500 earnings per share have been revised down for both 2022 and 2023. For calendar year 2022, S&P 500 earnings have been reduced by 1.3 per cent, with particularly large declines taking place in communication services (6.7 per cent), consumer discretionary (4.1 per cent) and technology (2.5 per cent).
The results are broadly similar for 2023: forecasted earnings have been trimmed by 1.7 per cent, with the largest negative revisions occurring in consumer discretionary (3.3 per cent), communication services (2.9 per cent), industrials (2.7 per cent) and materials (2.7 per cent).
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Note that outside of energy, the sectors that have held in the best (real estate, utilities and health care) are all defensive in nature. From our standpoint, if the earnings season had truly been “better than feared,” this is not the group that would be exhibiting relative strength. Rather, an economic trough would be marked by earnings upgrades to cyclical sectors, but this is not what we have seen (quite the opposite, in fact).
More On This Topic David Rosenberg: Five reasons we haven’t seen market bottom yet David Rosenberg: Roof is about to cave in on the Canadian economy David Rosenberg: Cyclical sectors next ‘shoe to drop’ — and the TSX is especially vulnerable Although investors cheered the second-quarter earnings season, we believe the optimism is misplaced. Beneath the surface, there was a very clear pattern of erosion in corporate profits, entirely consistent with a continued slowdown in the economy. In our view, we are in the early stages of an earnings recession, especially as the Fed continues to aggressively tighten into a deteriorating economic backdrop.
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Article content Indeed, based on an average of the 2000 and 2007 experiences, it took 418 trading days following the peak in the stock market until forward earnings estimates bottomed. We are only 160 days in this time around, reinforcing our belief that this dynamic is likely to take some time to play out.
With this in mind, we continue to advocate that investors be positioned defensively, meaning a focus on companies with limited earnings cyclicality and strong balance sheets. Furthermore, we would use this period of equity market strength as an opportunity to take profits, especially on high-beta cyclicals.
David Rosenberg is founder of independent research firm Rosenberg Research & Associates Inc. Brendan Livingstone is a senior markets strategist there. You can sign up for a free, one-month trial on Rosenberg’s website.
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