Amada Agati:  

In this edition of Adding Alpha, we're cranking up the volume on our album of the year as we take a look at Q4 earnings season to close out 2022 and the outlook for earnings in 2023, because earnings really are on Pink Floyd's 'Dark Side of the Moon' right now.

I always say earnings season is one of the four most wonderful times of the year for investors. It's really where the rubber meets the road in terms of market fundamentals and the price or value investors have assigned to those fundamentals. But let's just say this earnings season hasn't been quite so wonderful.

In fact, it's been a bit underwhelming and disappointing by the results and the guidance we've seen so far. S&P 500 earnings growth is tracking at about negative 5%.

If you exclude energy, it's more like down 8.4%. And even though energy is a small sector, it's still really creating outsized contribution to overall growth. What's notable is this is the first expectation for negative earnings growth since 2019 if you exclude the pandemic-induced 2020 recessionary quarters.

In our view, the earnings recession clock starts ticking with this quarterly results. The beat rate for earnings has been well below expectations. In average earnings season, the median beat rate is somewhere in the neighborhood of 4.5%, and yet upside surprises this time around are only tracking at about 1.5%, so a very wide margin of disappointment.

Even though we saw fairly significant negative revisions before earnings season began, this is really telling us that the bar hasn't been set low enough yet --i.e. analysts are still too optimistic about the growth outlook ahead.

If we zoom out and take a look at the chart, consensus earnings growth expectations are still hovering around 3.4% for 2023. Revisions have to continue moving lower from here if we're heading into a mild economic recession later in the year.

If you'll note at the far left of the chart, all the way back in 2015 and 2016, the earnings recession at that time was really led by the mega cap stocks. At that time, they grew earnings 20-plus percent while the overall S&P 500 earnings growth was about flat. And I think what's important this time around is that they're not going to be there to support or offset the market, and that really has
important implications for how far earnings might fall this time around.

In a mild recession scenario, earnings typically fall from about 10% peak-to-trough. But 2023 earnings per share is still sitting at about $230, or only about 4% off peak levels. By the math, there's at least
600 basis points to go in terms of a growth rate deceleration from here.

Based on how quickly leading economic indicators are falling and if the Fed doesn't effectively pause its tightening cycle, we do think the earnings decline is probably larger than 10%.

At an 18 times forward PE, we are not priced at recessionary valuation levels, which could translate into another 10 to 15% downside from current levels. But is that where the story ends? Let's hope not.

With that underwhelming outlook for earnings, we've naturally been getting a lot of questions about the shape of the returns profile for the year. 

Is it a W? Is it a U? Is it a square root? Is it a bathtub shape? Is it a capital I, meaning straight down from here? So what does the crystal ball tell us about the path forward for returns?

In this case, we think 2023 will likely be a tale of two halves. Now don't quote me as saying the precise inflection point for markets is going to be June 30. It's probably more like a first leg, second leg kind of scenario. In any case, we think it's going to be more of a V-shaped returns environment --a fairly choppy downward pressure on the first half, with the Fed still firmly in the driver's seat, tightening financial conditions and tipping us into a recession sometime during Q2.

Followed by a bounce in the second half as the market starts to anticipate the end for Fed tightening, inflation starts to come a bit more under control, and the recession appears to be fairly mild or short-lived.

Under this scenario, we'd expect valuation multiples to bounce back to a degree, maybe two to three multiple points, all else equal. And so, in that environment, we could manage to eke out low-single digit positive returns for the year, which is really why it's so important to see 2023 earnings revisions start to bottom out, as soon as by the end of the first quarter.