Earnings Recession Disappears from View as Wall Street Eyes a Bright Future

The Current Scenario: Wall Street's Prospects and Expensive Market Levels

The U.S. earnings recession, once the widely accepted belief just a few months ago, has now vanished from sight. At first glance, this disappearance should provide a favorable tailwind for Wall Street in the coming year.

However, there is a flip side to this situation. The extent to which the market has already factored in this positive outlook through the robust tech-driven rally since March means that anyone entering the market now would be purchasing at expensive levels.

Moreover, for investors with a long-term perspective, the growth potential and appeal of Wall Street in comparison to Treasury debt may significantly diminish if borrowing costs fail to return to the historically low levels observed in recent years.

Second-Quarter Reporting and Market Expectations

The second-quarter reporting season for S&P 500 companies is commencing, and it is projected to reveal a 6.4% decline in earnings for the April-June period compared to the same period last year, according to data from Refinitiv's I/B/E/S.

Although this would mark the worst quarter in three years, it would not signify a technical recession. The first-quarter growth was a modest 0.1%, and estimates for the third quarter hover around 1%.

Remarkably, some analysts suggest that the "whisper numbers" for Q2 indicate 1% or even 2% growth. If this proves true, it would be the ninth time since 2002 that negative forecasts at the beginning of the earnings season are positive, as Tajinder Dhillon from Refinitiv noted. The last time this happened was in the first quarter.

The Outlook for 2024 and Potential Challenges

The outlook for 2024 appears even more promising, with a projected near-12% full-year earnings growth. Among the market's 11 sectors, only energy and materials in Q1, and utilities in Q3, are anticipated to experience negative earnings growth in any quarter next year, based on Refinitiv's I/B/E/S data.

However, it is essential to approach this rosy outlook with caution. The S&P 500 index currently trades at a 12-month forward price/earnings ratio of 19.1, significantly above the 20-year average of 15.8, the 30-year average of 16.5, and the 40-year average around 16.0.

Although this high valuation is largely influenced by the tech sector, which trades at approximately 27 times forward earnings, it remains an optimistic forecast that relies on a favorable economic landscape and the absence of a recession.

Howard Silverblatt, senior analyst at S&P Global, remarks, "2024 earnings estimates have held up pretty well; we're at high levels now. You are paying a nice premium here. Hopefully, it's worth it."

Assessing the Risk and Potential Implications

Examining the equity risk premium (ERP), a metric that gauges the additional return investors expect from holding stocks in comparison to risk-free Treasury bills, reveals that stocks currently need to be priced attractively.

While it is a straightforward measure, the ERP serves as a reliable indicator of when stocks appear undervalued or overvalued. The ERP currently sits at its lowest point since 2004, implying that equities may not be a favorable risk at present.

Let's consider the post-pandemic world's potential shift away from low and zero interest rates, as many analysts suggest. Investors must brace themselves for a structurally more deficient ERP in the years to come. Alternatively, stocks could remain expensive for an extended period.

A study by Robeco's head researcher, David Blitz, conducted last year scrutinized equity risk premia across various countries using data spanning over 120 years. The findings suggest that total expected stock returns have no significant correlation, or potentially an inverse relationship, with risk-free returns. This implies that the ERP is considerably higher when the risk-free return is low and vice versa.

In the event that Treasury bill rates surpass 6%, the ERP might even turn negative. This challenges the conventional wisdom that stocks inherently carry a risk premium, irrespective of the prevailing risk-free rate. Blitz's research indicates that if he is correct, any increase in interest rates and bill yields will further compress the ERP.

Another working paper, authored by Federal Reserve economist Michael Smolyansky last month, paints a similarly gloomy long-term outlook for corporate earnings and stock returns but for different reasons.

Smolyansky argues that falling interest and corporate tax rates accounted for over 40% of real corporate profit growth from 1989 to 2019, with the decline in risk-free rates explaining the entirety of the rise in PE multiples.

Unless interest rates and Treasury yields revert to their lows post-2008 financial crisis, it is challenging to envision a continued expansion in PE multiples. The markets appear to be disregarding the "substantially lower" earnings growth that Smolyansky predicts will prevail in the future.

Smolyansky states, "With the expected slowdown in corporate profit growth and no offsetting expansion in P/E multiples, real longer-run stock returns in the future are likely to be no higher than about 2%, the rate of GDP growth."

Short-Lived Market Highs

While strong second-quarter results and the avoidance of an earnings recession could provide a boost to Wall Street, the euphoria may prove fleeting.

Anticipating the Future of Wall Street

Despite the potential short-lived nature of market highs, it is crucial to analyze the trajectory of Wall Street and prepare for the future.

Looking ahead, several factors could shape the landscape of the financial markets and influence investor sentiment.

Regulatory Environment and Policy Changes

Changes in regulations and government policies can significantly impact the financial markets. It is essential for investors to stay informed about potential shifts in policies related to taxation, trade agreements, and industry-specific regulations.

Additionally, geopolitical developments and international relations can introduce volatility into the markets. Keeping a close eye on these factors will enable investors to make more informed decisions.

Technological Innovations and Disruptions

The influence of technology on the financial markets cannot be underestimated. Advancements such as artificial intelligence, blockchain, and automation are reshaping various sectors, including finance.

Investors need to monitor emerging technologies and their potential implications for industries and companies. Understanding how technology can drive growth or disrupt established business models is vital for making sound investment choices.

Sustainable Investing and ESG Factors

Environmental, social, and governance (ESG) factors are gaining prominence in the investment landscape. Investors are increasingly considering the impact of companies' environmental and social practices and their governance structure.

Sustainable investing has gained traction as more investors recognize the importance of aligning their portfolios with their values. Companies prioritising ESG principles will likely attract more capital in the long run.

Market Volatility and Risk Management

Market volatility is an inherent characteristic of financial markets. Investors must have a robust risk management strategy in place to navigate turbulent times.

Diversification, asset allocation, and risk assessment are essential elements of effective risk management. By spreading investments across different asset classes and understanding the potential risks associated with each investment, investors can mitigate losses during market downturns.

Investor Education and Continuous Learning

Investing in the stock market requires knowledge and expertise. Investors should take the time to educate themselves about financial markets, investment strategies, and fundamental analysis.

Staying informed through reputable financial news sources, attending seminars or workshops, and engaging with experienced professionals can help investors make informed decisions and adapt to changing market conditions.

Footnote: Navigating the Road Ahead

Wall Street's outlook appears promising, with positive earnings growth projected for the coming years. However, investors must exercise caution due to elevated market levels and potential challenges on the horizon.

Assessing the risk-reward dynamics, staying informed about market trends, and having a well-defined investment strategy are essential for navigating the road ahead. By embracing a long-term perspective and remaining adaptable, investors can position themselves to make informed decisions and outperform in the dynamic world of finance.

As the financial landscape evolves, astute investors who stay ahead of the curve will be well-equipped to navigate the ever-changing currents of Wall Street.