Our economy has spent much of 2022 digesting inflationary pressures. And the effects have started to show in recent quarterly earnings.
As we discussed last week, big banks Morgan Stanley (MS) and Goldman Sachs (GS) are concerned that we're on our way to an "earnings recession." That happens when corporate earnings fall for two consecutive quarters.
As the full picture for second-quarter earnings becomes clearer, other outlets have started to echo this sentiment. But being in an earnings recession doesn't mean that our economy is in an actual recession.
To understand why, you have to consider the factors that could lead to this drop in earnings. It's at least partially due to the Fed raising rates as it looks to cool down the economy and slow inflation.
But there's another key reason for this downtrend. As Morgan Stanley explained, companies over-earned in 2021.
This over-earning was a result of government stimulus packages and a historic rise in consumer demand. This situation is very similar to what happened in 1945, as we explained back in July.
As the world recovered from World War II, soldiers returned home and started families. Demand for consumer goods skyrocketed, pushing corporate America's operations to unsustainable levels.
Gross domestic product ("GDP") in 1946 surpassed what should have been possible. So it made sense when earnings fell back to normal levels in the following years.
We've been experiencing the same thing today due to rising demand following the pandemic.
The Fed is trying to slow this demand in the hopes that inflation will follow suit. While this is in the economy's best interest, it will hurt near-term company earnings.
Tightening financial conditions have discouraged consumer spending and corporate borrowing.
Many economists argue higher costs for raw materials and rising wages are cutting into corporate profits. This will bring corporate earnings back to longer-run averages as a share of GDP.
It looks like after 2021's unsustainably high earnings, things are beginning to fall back to Earth.
At the start of the year, as-reported trailing 12-month ("TTM") earnings per share ("EPS") for the S&P 500 barely grew. That number rose a paltry $0.04, from $197.87 in the fourth quarter of 2021 to $197.91 in the first quarter of 2022. That's only 0.02% higher.
But that hasn't been the case for the second quarter.
More than 99% of companies have reported second-quarter earnings. Earnings dropped almost 3% quarter over quarter, down to $192.32.
This is the first S&P 500 earnings dip in the past six quarters... since the midst of the pandemic.
And third-quarter estimates don't look any better. Earnings are forecast to drop another 0.5% to $191.25. Wall Street analysis expects this decline to continue through the end of the year, bottoming at $188.20 before recovering in the first quarter of 2023.
Operating earnings – earnings excluding write-offs from management – paint a somewhat rosier picture. While they also show a drop in the second quarter, they're forecast to rebound sooner than EPS.
But that's not what you should be focused on. It doesn't matter whether market earnings return to growth this quarter or next year.
Even when overall corporate earnings show weakness, that doesn't mean every part of the economy is struggling.
The S&P 500's second-quarter dip was largely driven by declines in the consumer discretionary and financial sectors. TTM consumer discretionary earnings were down $3 in the second quarter of 2022. The financial sector's earnings have dropped a staggering $13 since the fourth quarter of 2021.
These two underachievers pushed the entire index down. But some pockets of the market were stronger... The energy sector's TTM earnings increased almost $20 from the first quarter of 2021. Health care earnings rose $2.
It's hard not to focus on the direction of the market as a whole – especially when that's all the mainstream financial media can talk about.
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September 19, 2022