Hey, friends, it's time for another edition of "Adding Alpha," and we're taking stock of second quarter earnings season. Which themes and trends are the winners and losers, and what does the path forward hold? So let's dive right into it.
At a growth rate of negative-5.2%, it's the third consecutive quarter of negative growth. So while we continue to expect an economic recession later this year, the earnings recession is already under way. However, a few things to call out.
Excluding the energy sector, the growth rate is actually a positive 1.5% at this point in earnings season.
Second, upside surprise of 725 basis points is coming in well ahead of the 10-year average. Earnings results by these metrics are actually better than feared.
Two sectors that had very low expectations coming into earnings season were energy and financials, and we saw net interest margin compression and CapEx cutting into profit margins.
That might not be what investors really want to hear based on the fairly muted stock price reactions, but earnings data came in okay for areas where performance has really lagged this year.
Let's shift gears and talk revisions for Q3, which have been steadily declining and stand at about 0.22% now.
If you remove Amazon, the estimate drops into negative growth territory to the tune of negative-0.39%. Translation, we're on pace for a fourth straight quarter of negative growth, and the slow march toward an economic recession continues.
The only sectors where we're seeing positive revisions are communication services, consumer discretionary, and tech. Not surprisingly, they're also the ones leading market performance by a wide margin year to date.
A quick check-in on the consumer and a few anecdotal takeaways from Q2 earnings season show we're starting to see some erosion in consumer health and consumer behavior.
Both Chipotle and Starbucks missed sales estimates, and then Apple reported sales results that barely met expectations. I call these three out for a reason, because they're very much a part of the daily life of upper-middle income consumers, and yet their sales trends are weakening. It fits with our outlook for a mild recession looming.
If we zoom out and take a look at expectations for the balance of the year and beyond, consensus is still expecting a positive 7.6% growth for Q4, a positive 1% for all of 2023 and a whopping 12% growth for 2024, which just seems way too high and optimistic across the board.
We think those estimates need to come down, as the lagged effect of the Fed's aggressive rate hikes start impacting earnings growth, which should lead to markets giving back some of the gains we've enjoyed year to date.
S&P 500 next 12 months consensus earnings per share is at a year to date high of approximately $236 and only a couple percentage points off the all-time high from last summer.
We still think peak to trough earnings could decline by as much as 10% as we move into a mild recession later this year, so it's a decent amount of downside to go.
We also still think at least a 10% to 15% pullback from present levels seems appropriate, especially given the economic headwinds facing China, facing Europe, and the fact the Fed hasn't given the all-clear signal yet on tightening monetary policy further from here.
Even though we've seen a little bit of multiple contraction recently, at a forward P/E of 19 times, market valuation definitely looks stretched.
When we look under the hood, the top 10 stocks are trading at a forward P/E in excess of 31 times, while the remaining 490 stocks are at about 16 times, which is still above the long-term average.
The market believes this time is different, doubling down on a no-landing scenario, but we just aren't convinced, which is why we continue to emphasize quality here.
Whether it's a mild recession or an extended slowdown of the business cycle, we like stocks that can consistently grow earnings in that slow growth world.