Wall Street’s Profit Forecasts Are in ‘La-La’ Land. Stocks Need to Adjust.
By Lisa Beilfuss
Fed chief Jerome Powell, shown at a conference in Washington last month, has started to suggest a soft landing for the economy is unlikely. Someone needs to tell Wall Street./ Kevin Dietsch/Getty ImagesThe micro picture doesn’t match the macro reality, meaning stock investors are likely in for more pain.
Since the Federal Reserve raised rates by three-quarters of a point in mid-June, economists across Wall Street have rushed to change their recession calls.
Accelerated monetary policy tightening has doubled recession odds, says Lisa Shalett, chief investment officer at Morgan Stanley Wealth Management MS +0.91% , noting that most economic models now suggest that the probability of a recession during the next 12 months has doubled to over 50%.
The bond market has started to reflect that probability, with Treasury yields slipping as investors turn to safe havens.
Stocks are another story, says Shalett, even given the steep losses so far this year.
Looking at the S&P 500 alone, a 20% decline since the start of 2022 represents a loss of about $9 trillion from its Jan. 4 peak and reflects almost a complete unwinding of the impact of fiscal and monetary Covid-19 stimulus, she says.
But since the Fed’s June rate hike, the S&P 500 has risen 3%.
And analysts are still predicting double-digit earnings growth for the rest of the year.
“Analysts are in la-la land,” says Vincent Deluard, director of global macro strategy at StoneX Group. He finds the recession debate misplaced and boring.
If there is anything interesting about it, he says, it is that the likelihood of recession is totally ignored by stock analysts.
Shalett of Morgan Stanley quantifies the blind spot.
“We find such resilience by markets and obstinance by analysts to reflect [rising recession probability] in their forecasts as a risk that could cost equity investors another 5% to 10%,” Shalett says.
Until 12-month forward earnings estimates fall 5% to 10%, the bear market is not over, she adds.
Deluard’s own macro model, based on four factors including the price of oil and the prime rate, suggests S&P 500 earnings will contract by 4.7% over the next year.
There may be something at work beyond the obstinance Shalett blames.
Deluard digs into the broad expectations for an imminent acceleration in S&P 500 earnings—which, he notes, analysts expect to grow by about 11% year-over-year in both the third and fourth quarters.
Consider two points he makes.
First, analysts are most bullish on consumer sectors, even as sentiment deteriorates, inflation erodes purchasing power, and the cost of credit rises.
Wall Street projects a 27% year-over-year rise in earnings across the consumer discretionary sector in the third quarter; those earnings fell 12% in the first quarter.
Second, consider a big expected deceleration in earnings growth across cyclical sectors, with earnings growth across materials and industrial companies collapsing before turning negative in 2023.
There is only one way to square those two predictions, he says.
Analysts expect a “disinflationary boom,” where inflation dissipates quickly as the economy meanwhile remains strong enough to generate double-digit earnings growth across consumer sectors.
That sounds a lot like the “soft landing” scenario that even Fed Chairman Jerome Powell has started to suggest is unlikely, meaning the disinflationary-boom scenario upon which current earnings estimates are built is at odds with reality.
“Inflation will stay at a plateau of death this summer, jeopardizing hopes for a brief hiking cycle and a dovish pivot in 2023,” Deluard says.
There is no plausible scenario where we move from a current inflationary boom—which is rapidly moving toward stagflation—and into the kind of “disinflationary boom” implied in analysts’ earnings forecasts, he says.
That is not to dismiss recent declines in commodity prices.
Those drops have renewed peak-inflation hopes, but they are on account of an economy that is already weakening as the Fed embarks on more policy tightening.
What is more, energy is the place where inflation is most acute and most stubborn, and it is hard to see broad, meaningful disinflation given supply and demand dynamics in the market.
Consider inventory data released during the week by the Energy Information Administration.
U.S. crude oil inventories fell by 2.8 million barrels in the week of June 24, about five times the drop analysts polled by Reuters projected and a drawdown that leaves domestic crude oil inventories about 13% below the five-year average for this time of year.
Short supply is why some energy analysts remain mega-bulls.
“Recession or not, we believe that the oil complex remains in a structural, multi-year tightening cycle,” analysts at RBC Capital Markets say, noting the “strongest fundamental oil market set up in decades, maybe ever.”
They say gasoline prices would need to rise to $6.60 a gallon—about 35% from current levels—to trigger the kind of demand destruction observed in 2008.
It may take a lot longer than expected for high prices to cure high prices, then, meaning more damage along the way as persistently high energy prices ripple across the economy.
Putting it all together, Deluard says U.S. stock valuations aren’t attractive.
He says the “true” forward S&P 500 price-to-earnings ratio is around 20, which translates to an earnings yield below 5%.
If TINA, or “there is no alternative,” was the mantra of the bull market, Deluard says TIA, or “there is an alternative,” may become the motto of this bear market, with viable alternatives in parts of the bond market.
That, of course, assumes the Fed fights inflation through the economic downturn.
Nick Reece, strategist at Merk Investments, says the recent spike and subsequent decline in the two-year Treasury yield suggests a dovish Fed pivot may have already started.
That yield typically peaks at or before a Fed tightening cycle peaks, and it peaks above where the policy rate winds up actually topping out, he says, calling the two-year yield a real-time proxy for Fed pivots.
“So, I’m starting to think the next hike might actually be the last for this cycle,” Reece says.
Deluard and Reece are saying similar things from different angles.
Inflation seems more likely than not to remain elevated.
If it doesn’t, it’s in part because the Fed remains aggressive at the expense of growth.
Either way, Wall Street’s earnings expectations don’t match the macro reality.
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