The first deep-dive on US corporate earnings done in The Worked Shoot was last May in An Optimistic Catastrophe. From that piece:
During the 2000-2003 recessionary bear market period, and then again in the 2007-2009 period, operating profit margins went to about 5% and the P/E ratio on those margins went to about 17 (using quarterly data). Even if inflation is sticky and nominal GDP grows at 10% this year (sales actually went down during the 2000-2003 and 2007-2009 periods) and sales growth is the same, then this is the simple arithmetic:
1566.80 in sales x 1.10 = 1723.48 2022 sales
1723.48 in 2022 sales x 5% operating margin = 86.17
As with all such exercises, this provided a basic framework for examining and stress-testing what a potential recession could look like relative to the impact on corporate earnings. S&P has released most of its final 2022 data, and here is where things shook out:
Sales 1,752.89
YoY Increase % 11.88
Operating EPS $196.95
Operating Margin % 11.24
S&P 500 12/31/2022 3,839.50
P/E Ratio 19.49
The US was not in recession for any material part of 2022 and the year continued a period of money illusion with relatively high levels of nominal GDP and inflation rolling over and decelerating in the back half of the year.
To revisit this exercise for stress-testing purposes, a 5% increase in sales for 2023 would result in 1,840.53, and then any margin and P/E ratio can be selected to consider index price levels.
For example, an 8% margin and 18 P/E would equal SPX 2,650. A 10% margin and 18 P/E would be 3,312. With the S&P 500 Index trading around 4,150 as of this writing, that ‘translates’ to a P/E of over 22 assuming 5% sales growth and 10% operating margin.
Relative to a cycle-time frame margin for error, I believe Wall Street consensus is completely out to lunch.
While pinpointing an exact date as to when the NBER eventually settles upon the beginning of the current recession, I will stress “current recession.” Year-over-year quarterly sales growth for Q4 2022 decelerated to 9.04% from 15.16% in the prior year period. Operating earnings for Q4 2022 declined by -11.21%, with the operating margin declining from a cycle peak of 13.29% to 11.24%. Notably, the quality of those earnings was also trending in a bad direction, as the difference between operating and net earnings increased to over 14% from just 5% for Q4 2021.
This opens up a pet peeve of mine, which is that the concept of ‘one-time’ expenses can be reasonable for a specific company, or even an industry. For example, airlines incurred very specific one-time costs associated with the grounding of flights in September 2001. However, at the broad index level, there are ALWAYS companies experiencing one-time expenses, which means for the index they are not….one-time.
Similar to the period of the late 1990s, the disparity between operating and net earnings has horseshoed. Back then, one-time charges grew starting with the Asian contagion in 1997, which rolled into the full-blown emerging market crisis and Long-Term Capital Management implosion in 1998 and persisted through Q3 1999. From that point, as a recovery in emerging markets gained traction and Y2K stimulus kicked in, the disparity dropped from the 14-17% range back down to as low as 5.75% in Q3 2000, which proved the trough heading into the 2001 recession.
Q1 2001 jumped to over 16%, with the recession subsequently dated by NBER to have begun in March. By Q4 2001, operating earnings had declined over 30% from the Q3 2000 peak, with the disparity with net earnings skyrocketing to over 57%. It would not be until Q4 2005 that the disparity dropped back below 10%, where it remained until Q3 2007 when it ran back up to 13.62%.
We now know that NBER eventually dated the start of the GFC recession as December 2007, and by Q1 2008 the disparity between operating and net earnings had already ramped up to almost 25% and increased to over 41% for Q3 2008, which concluded prior to the aftermath of the Lehman Brothers bankruptcy and subsequent cascade.
An Optimistic Catastrophe was written as a way to get prepared for the potentiality of a recession and what that would likely mean for US corporate earnings. Given the backdrop of leading indicators remaining very negative (indicating a severe global recession unfolding at least over the remainder of 2023), along with major central banks like the Federal Reserve STILL TIGHTENING, I am updating the prior title to simply, A Catastrophe.
I believe a reasonable base case for 2023 S&P 500 sales is a decline of -5%, which would result in 1,748.50 in sales. Even if I use a linear continuation of the recent deterioration in margins (suspect it will accelerate), a further decline of 2% would result in about a 9% operating margin, or operating earnings of about $157. A more typical recessionary margin of 6% (still higher than either 2001 or 2008 troughs) would mean $105 in operating earnings.
A 10% or greater decline in sales amidst a severe global recession would not surprise, and that would put sales at about 1,656, and one can rinse and repeat the margin and P/E multiple game to generate SPX price levels. A 5% margin on that lower sales figure would be about $82 in SPX operating earnings and a 19 P/E on those would result in a price that re-tests the double top area just below 1,600 from the years 2000 and 2007.
None of these are ‘forecasts,’ but rather a way to contextualize the abrogation of prudence amongst so many investors relative to how little margin for error there is at present for a prudent investor. In the era of central bank activism, fiscal largesse, and too many market manias to mention, are there any prudent people left, or have they all gone the way of the Dodo Bird?
Timely update... The weakening of *nominal* retail sales, released today, suggests your "current recession" comment is fully warranted. I hope, at some point, that fundamentals matter again, but we might have to wait for labor market weakness to stem the flow of price-insensitive flows into equity markets.
A test to 1600 would be "catastrophic" indeed but very cleansing, correct? Kayfabe, would a market decline that great necessarily put an end to inflation, or in this post-pandemic world is 2% inflation a pipe dream. In that scenario, do you think QE would begin again or would fear of re-inflation cause the FED to think twice? [Political pressure at that moment would be tremendous given that unemployment would necessarily have to be terrible. Not to mention the bankruptcies...] Thank you for this weeks piece. Always valuable. Appreciate you.