“Death By Paper Cuts” Begins
After two weeks of torrential corporate reporting, Q1 earnings season is almost over, with 89% of the quarter’s earnings now in from 438 S&P 500 companies.
Looking back, first the good news: consensus Q1 EPS has risen 6% since April 1 to $54.57 (+11% YoY), better than Bank of America’s forecast 4% beat of $53.50, as all 11 sectors are ahead and 56% of companies beat on sales and EPS, vs. the 39% historical average.
Unfortunately, that’s as far as the good news goes, and it’s all in the rearview mirror.
Now the bad news.
First, as we discussed last week, underneath the market’s surface, two big COVID demand reversals are happening this quarter. First, a rapid shift from rate-sensitive big ticket items (housing & autos) to services, which will be a headwind for S&P earnings (50% goods vs. 20% goods for the economy). Second, Tech earnings are lagging. As the second chart shows, 2022 consensus earnings as % of S&P 500 earnings are now below are now below where it stood at the end of 2020, implying to full reversal of COVID-driven demand pull forward.
Second, demand destruction has arrived: mentions of “weak demand” jumped to the highest level since 2Q20 earnings (Exhibit 15). US companies cited as many instances of weak demand as Europe, where macro headwinds are more severe from Russia/Ukraine.
Third, the Bank of America guidance ratio, earnings revision ratio, and corporate sentiment reading all plummeted to the lowest since 2Q20, adding to recession concerns. To wit: other than the COVID-impacted 1Q-2Q20, this marks the lowest level since 2Q16 when trailing 12-mo. EPS fell 2.7% peak-to-trough. The sentiment score has also been highly predictive of the following quarter’s earnings growth YoY (54% r-sq), and points a sharp drop in earnings ahead.
Additionally, Companies’ mentions indicate a sharp drop in business conditions, with the spread between “better” or “strong” vs. “worse” or “weaker” falling to the lowest level since 2Q20. Companies’ optimism fell slightly QoQ, but remain above the historical average.
Fourth, despite stubbornly high consensus sellside expectations including record profit margins for the rest of the year…
… history suggests downside risk to consensus earnings: as shown below, analysts typically start the year too optimistic and cut estimates throughout the year. Since 2001, actual EPS came in 5% below where consensus stood at the beginning of the year on average (-1% excluding 2008 and 2020). Consensus EPS for both 2022 and 2023 continued to climb higher YTD (both +2%) driven by higher Energy earnings, but expect downside risks given weak guidance and slowing macro conditions.
Which brings us to the fifth, and most important factor: the beginning of “death by paper cuts”: as BofA notes when relaying what it heard on the street, “2022 EPS have been revised up.” But without Energy (2022 EPS up 62% YTD), S&P 500 2022 consensus EPS is down 0.5% YTD. Downward revisions were most acute in Cons. Disc. (-10%), whose earnings are negatively correlated to Energy’s.
Here extending on the downbeat trend noted last week, Bank of America writes that the 3-month guidance ratio (# of above- vs. below-consensus guidance) fell even more to 0.6x so far in May, the lowest level since May 2020. Similarly, the 3-month Earnings Revision Ratio sharply fell to 0.8x, also the lowest level since June 2020: “We see downside risks to consensus EPS”, BofA concludes.
And here is where the pain comes full circle: while consensus 1Q EPS climbed +2ppt, but full-year 2022 EPS fell 0.5%, the biggest weekly decline this year. Margin cuts began, but analysts pushed out record margin expectations to 3Q from 2Q. This is all typical of the calendar: since ‘01, actual EPS came in 5% below consensus at b/o/y, implying more cuts to come.
As Bloomberg Intelligence puts it, “all year long, investors have clung to still-strong earnings as one reason for optimism, but analysts have reduced 2022 forecasts for two weeks in a row now.” Though the downgrade is small, at less than $1, not since June 2020 have they lowered estimates by a longer stretch.
Summarizing the bank’s observations, BofA’s Savita Subramanian warns that the bank sees risks to 2023 earnings even under a no recession scenario: “We are 8% below consensus, and see risks to earnings in Consumer Discretionary, Materials and other big ticket exposed sectors. Signs of slowdown were evident in big ticket items (housing, autos) and COVID pull-forward sector beneficiaries. Under a recession, we see risks of a 10% drop in eps next year.”
While BofA’s below consensus outlook may be an outlier right now, it will soon be consensus: as Meera Pandit, a global market strategist on the J.P. Morgan Asset Management Global Market Insights Strategy Team, said on Bloomberg TV, “It feels like the market is leaning into the worst-case outcomes. Risks on the horizon are materializing and the market is trying to price that in. There’s a whole lot of uncertainty.”
“Rising estimates and price targets are emblematic of bull markets, and when numbers and targets are coming down, we’re clearly in (at best) a deep correction or (at worst) a bear market,” wrote Nicholas Colas, co-founder of DataTrek Research. He added that the “silver lining” is that “we can’t bottom convincingly until stocks stop going down on estimate/target cuts. The latter process has finally started. Now we just need stocks to stabilize as the Street further reduces estimates/targets.”
Tue, 05/10/2022 – 07:00