Why the Stock Market is Outperforming Amid an ‘Earnings Recession’
Corporate earnings growth is expected to be negative for the second consecutive quarter, but historical data indicates the stock market has held up well during previous earnings recessions
Earnings season for Q1 2023 kicks off during the second week of April and the prognosis for profits in the U.S. corporate sector isn’t great.
But, based on historical data patterns, that may not be the worst thing for the stock market.
According to FactSet, an American financial data and software company, corporate earnings are projected to drop by nearly 7% in Q1 2023, as compared to 12 months ago.
The last time corporate earnings dropped so precipitously was during Q2 2020 when the onset of the COVID-19 pandemic completely devastated corporate profits. Q2 2020 earnings dropped by roughly 32%, as compared to Q2 2019.
This time around, the slowdown in the economy is far less pronounced than it was in 2020, which is why corporate earnings are holding up—at least for the time being.
If current projections for Q1 2023 come to fruition, then corporate earnings in the U.S. will officially be in recession, which is defined as two consecutive quarters of declines in earnings growth.
In addition to Q1 2023, the last quarter of 2022 also saw a pullback in earnings when the S&P 500 posted about a 5% decline in earnings, as compared to the year prior.
Based on current estimates, the earnings recession could persist for at least one more quarter, as Q2 2023 is also expected to show negative earnings growth. Current consensus projections suggest that corporate earnings could drop by another 4% in Q2, as illustrated below.
Despite the recent slump in earnings growth, overall net profit margins for American companies are still hovering near record highs. The five-year average profit margin in the U.S. business sector is roughly 11.4%, which is slightly above the projected profit margin in Q1 2023, which is 11.3%.
These figures indicate that earnings in the American corporate sector remain robust, despite the onset of an earnings recession in the last two quarters.
As illustrated below, corporate profit margins climbed to historic highs in 2022 before pulling back in Q4 2022 and Q1 2023.
Q1 2023 earnings season shifts into high gear on April 14 when some of the country’s largest banks are scheduled to release their quarterly results.
Bank earnings are of particular interest at this time due to the recent bank failures in the U.S., and most of the investment world will be watching closely to see if any important updates are revealed during the forthcoming earnings season.
The first four banks scheduled to release their results are Citigroup (C), JPMorgan Chase (JPM), PNC Financial (PNC) and Wells Fargo (WFC). PNC’s results will be of particular interest because it is a regional bank, much like Silicon Valley Bank (SIVBQ).
Negative earnings growth doesn’t sound like a great thing for corporate valuations, but these periods don’t necessarily guarantee poor performance in the stock market. In fact, the stock market has exhibited above-average performance during a couple of the most recent earnings recessions.
The last four earnings recessions were observed during 2008-2009 (eight consecutive quarters), 2012-2013 (three consecutive quarters), 2015-2016 (six consecutive quarters) and 2020 (four consecutive quarters). During those periods, the S&P 500 posted the following annual returns:
- 2008: -39%
- 2009: +23%
- 2012: +13%
- 2013: +29%
- 2015: -1%
- 2016: +10%
- 2020: +16%
For reference, the average annualized total return in the S&P 500 over the last 90 years is approximately 10%.
Earnings recessions on their own don’t appear to signal a forthcoming decline in equity prices, at least according to historical data patterns. But, when an earnings recession has developed in the midst of a real economic recession—as observed during the 2008-2009 Financial Crisis—the results were cataclysmic.
During the 2008-2009 Financial Crisis, the corporate sector experienced eight straight quarters of negative earnings growth. In conjunction with the earnings recession, the real economy was in recession from December 2007 through June of 2009.
Those combined developments triggered one of the sharpest corrections in stock market history, as the S&P 500 dropped roughly 57% from peak to trough during the Great Recession.
This example serves as an important reminder that earnings recessions on their own haven’t acted like kryptonite for the stock market. However, when a real recession develops in conjunction with an earnings recession, things get complicated.
As shown below, the stock market has historically performed well leading up to a recession, but tends to underperform after a recession gets underway.
The COVID-19 pandemic also featured an earnings recession alongside a real recession, and the stock market pulled back sharply during this period, but only for a short time. The unique nature of the pandemic makes comparisons to other recessionary periods somewhat complicated.
To learn more about trading strategies commonly employed during earnings season, check out this installment of Best Practices on the tastylive financial network.
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Sage Anderson is a pseudonym. He’s an experienced trader of equity derivatives and has managed volatility-based portfolios as a former prop trading firm employee. He’s not an employee of Luckbox, tastylive or any affiliated companies. Readers can direct questions about this blog or other trading-related subjects, to firstname.lastname@example.org.