The big risk to equities now is earnings, not valuations

The writer is co-founder and chief investment strategist at Absolute Strategy Research

As global equities go deeper into bear market territory, it is important to recognize the unusual nature of this sell-off.

The pain so far has come largely from a contraction on the valuation placed on the more expensive stocks and their earnings prospects. This means we have probably only seen the first phase of this bear market.

With valuations having come down so far, the greatest risk to equities now comes from actual earnings falling short of current expectations. The next leg of the bear market is likely to be driven by earnings recessions, especially in the more cyclical stocks, sectors, and markets.

So far, the compression of valuations – measured by the ratios of price to trailing earnings for global stocks – has been the greatest since the stagflation of 1975.

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Despite all the recent gloom hanging over markets, stock analysts’ forecasts point to uninterrupted gains in global, US and even eurozone earnings for this year, 2023 and 2024.

This continued confidence contrasts with all the talk of recession as the US Federal Reserve tightens monetary policy, raising rates. And it comes in the face of a sharp slowing of activity indicators, a collapse in chief executive confidence, the start of a moderation in pricing power and a strong US dollar which increases costs for non-American companies.

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The current data signal is a synchronized slowdown around the world. Rather than uninterrupted earnings per share growth, our models point to an earnings recession in the year ahead. We expect US earnings to fall by an 10 to 15 per cent over that time.

Perhaps even more impressive is that the consensus EPS forecast for the Euro Stoxx index companies is signaling increasing earnings expectations despite the war in Ukraine and a cost of living crisis that is likely to raise costs and reduce demand for corporations. Our “top-down” forecasts suggest that eurozone EPS could fall by an annualized 20 per cent in the year ahead.

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Any earnings recession will have its greatest impact on cyclical sectors such as industrials, tech hardware and energy. Currently, energy is forecast to post the strongest earnings growth of any of the main industry groups, both in the US and globally. However, almost every global earnings recession has seen energy earnings growth in negative territory.

This means that for our earnings recession call to be correct, we will probably need to see oil sector earnings slow sharply.

Currently, however, the energy sector EPS forecasts for the year ahead are the strongest of any of the main industry groups. It may be that supply constraints and the Ukraine war may make things “different this time”.

However, if we look at the official US forecasts for oil inventories from the US Energy Information Administration and take into account the fact that economic recession will depress oil demand, our models point to double digit falls in oil EPS growth in the year ahead.

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That energy analysts are reliant on a “this time is different” mindset is evident in EPS forecasts for value and growth stocks.

Value stocks tend to come from the more cyclical sectors in the economy, such as energy, industry and finance. In the past, such sectors have shown greater earnings volatility.

In this economic cycle, value stocks are expected to see continuous EPS gains over the next two years, while earnings expectations for growth equities have already fled to moderate.

The irony is that analysts have been much more willing to cut their forecasts for growth stocks. This is despite the fact that, historically, they are the ones that have tended to deliver more stable EPS growth. If activity slows, rate rises come to a halt and bond yields start to stabilize or come down, then these growth stocks will have already more realistic EPS forecasts and may be well placed to rally relative to value “plays”.

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There is little doubt we are in unusual, volatile times for investors. But the rationale of “this time is different” to explain stock market conditions has been a recurring warning sign for investors, cycle after cycle. If central banks succeed in reining in the current surge in inflation by damping demand, earnings should follow suit. That means more pain for equity investors.

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