Will Falling Earnings Expectations Weigh on Stocks in 2023?
2022 has been quite an unsettling ride for the stock market. After years of near-constant upward momentum, stocks have experienced renewed volatility amid a host of macroeconomic headwinds and disruptions that have emerged or intensified throughout the year. From rising inflation to tightening interest rates, stocks have faced their toughest test in decades, save perhaps for the short-lived market chaos that accompanied the outbreak of the Covid-19 pandemic.
The mounting pressures have not gone unnoticed by Wall Street. Indeed, many analysts and strategists have felt compelled to make significant downward revisions to their expectations of forward corporate earnings in response to the issues.
Downward revisions aplenty
On Dec. 1, Dubravko Lakos-Bujas, the head of U.S. equity strategy at JPMorgan Chase & Co. (NYSE:JPM), predicted market uncertainty and economic weakness will persist deep into next year and that the situation is likely to get worse before it gets better:
"Fundamentals will likely deteriorate as financial conditions continue to tighten and monetary policy turns even more restrictive (Fed raises rates by another 75-100bp with an additional ~$1T in QT), while the economy enters a mild recession with the labor market contracting and unemployment rate rising to ~5%...We expect S&P 500 to re-test this years lows as the Fed overtightens into weaker fundamentals."
Lakos-Bujas increasing pessimism is reflected in JPMorgans latest formal guidance for 2023 earnings, which is down 9% from the investment banks previous estimate. According to JPMorgan, the stock market is headed for a serious rough patch in the first half of 2023 that will put significant downward pressure on individual stocks and broad indexes alike.
JPMorgan is hardly alone in its near-term pessimism. As Factsets John Butters observed on Dec. 2, the past couple of months have seen analysts across Wall Street and beyond revising their estimates downward at a historic clip:
During the months of October and November, analysts lowered EPS estimates for S&P 500 companies for the fourth quarter by a larger margin than average. The Q4 bottom-up EPS estimate (which is an aggregation of the median EPS estimates for Q4 for all the companies in the index) decreased by 5.6% (to $54.58 from $57.79) from Sept. 30 to Nov. 30 The decline in the bottom-up EPS estimate recorded during the first two months of the fourth quarter was larger than the five-year average, the 10-year average, the 15-year average and the 20-year average. The fourth quarter also marked the largest decrease in the bottom-up EPS estimate during the first two months of a quarter since Q2 2020 (-35.9%).
In other words, analysts have not only slashed their earnings per share estimates for virtually all of the major companies that constitute the S&P 500 index, but have done so to a degree rarely seen in recent history, save for the one-off disruptions related to the global pandemic. Even conventional financial crises rarely see such rapid downward revisions across the board.
Dangerous divergence
After suffering an extended beatdown for much of the year, stocks have recovered somewhat in recent months. Since reaching a nadir in October, stock prices have seen some positive momentum. However, the market is still down considerably from the start of the year. The S&P 500 Index, for example, is now up 10% from its October low, but still down more than 17% year to date.
One would expect the recent flurry of downgrades and forward earnings estimate cuts would weigh on stocks, but this has not been in the case. Thus far, analysts recent downward revisions have done little to blunt the market rally. This could become a real problem in 2023, as CNBCs Bob Pisani pointed out on Dec. 1:
With stock prices rising and earnings estimates declining, we are now witnessing a dangerous expansion in the 2023 multiple (P/E ratio). How wide? It depends on where you think estimates will land. Just as a reminder, 17 times forward earnings is the historic average. At an optimistic valuation of $231, we are already that now. To justify multiples toward 20 for any length of time, investors must believe that the economy is expanding and earnings prospects are improving. But we are going in the opposite direction. That sets up for a dangerous showdown.
Conventionally, falling forward earnings expectations tend to result in falling stock prices. When stock prices fail to fall, earnings multiples expand. When the economy is expanding strongly and financial market optimism is running high, multiple expansion is a welcome event for most investors. When the economy is struggling, however, multiple expansion makes stocks more expensive, sometimes dangerously so.
My take
Stocks have continued to recover from their October lows, seemingly in defiance of analysts darkening forward expectations. As earnings multiples expand, so, too, does risk of reversals. While value investors tend to be especially mindful of such risks, in my experience, the majority of market participants appear to be sanguine about them thus far.
However, should the economy continue to look shaky, let alone suffer another substantial shock or disruption, investors resurgent confidence risks melting away, in my assessment. Heading into 2023, investors would be well served to be mindful of the rising risks that attend any divergence between earnings expectations and securities prices.
Trade carefully.
This article first appeared on GuruFocus.
