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It’s all about the E, as in Earnings

| January 24, 2023

We mentioned last week that we were getting into the heart of the 4th quarter earnings reporting season and the banks kicked it off with somewhat mixed results. Netflix was last week, the first of the many big tech companies to report. Wall Street reacted favorably to what it heard.

Keep in mind, though, that the stock is down from $700 a year ago (now $363.63 on this chart), so top to bottom was down roughly 75%. While the headlines will gravitate to its doubling off the bottom, there is still work to be done on that stock. Tomorrow, we have Tesla earnings and they will likely prove to be big for the markets (one way or the other). Let’s not get too caught up in individual names, though, and instead widen our scope to look at the entire S&P 500 earnings expectations.

For that we turn again to our good friends at FactSet to inform us on current expectations.

As you can see, aggregate earnings per share peaked around $240 in the middle of last year and now are expected to finish 2022 around $220. Here’s a look at what forward earnings projections look like on an annual basis (blue bars are realized earnings in fully-reported prior years, grey bars are forecasted earnings for 2022 and beyond).


FactSet is expecting a growth of 4% for 2023 to $227. So, here’s the rub. If we have a recession in 2023, there is somewhere between slim and nil that earnings will grow for the year, and slim just left the building, in my opinion. By and large, analysts tend to be an optimistic group of people. It is typical that earnings for the year ahead start high and come down over the course of that year. We see it year in and year out. Let’s look at what Goldman Sachs published back in November, before many of the layoff announcements were made.

They are noting a 7% decline in earnings for 2023 across the entire S&P 500. So, what would that look like? From $220 for calendar year 2022 less 7% gets us to around $205 in earnings. You know our base case is somewhere around $200.

So why is this important?  Two reasons.

  1. As analysts reduce their earnings assumptions over the course of the year, adjusting for “unexpected” things like a recession, that will put some downward pressure on stock prices. That will be the case until they have sufficiently discounted the downside of earnings, at which point you can see a real recovery in earnings.
  2. But let’s not forget that stock prices reflect the discounted value of future streams of earnings. Let me get into that for a minute.

“Chris, you promised me two things if I read this. One was there would be no math and two, you wouldn’t get too technical because you know my eyes glaze over when it gets too complicated.” Unfortunately, to look at item #2 above, I’m going to need to violate both of those promises this week. My apologies. There will be a little bit of math (see the formula below) and I will try and keep the technical stuff in normal English. So, let’s do a little bit of work with the Capital Asset Pricing Model (CAPM). This works for both individual stocks and markets.

Let’s work through this and figure out the answer. We can use the 10-year Treasury as the risk-free rate of return. This is currently around 3.5%. Next, we will see what the expected return…ok, maybe I’m getting too far into the weeds. Let’s ditch the formula and make this really simple. A dollar of earnings a year from now is worth less than a dollar of earnings today. We will discount future earnings by the rate of inflation and sum up all the future yearly streams of earnings. That number would be our “fair value” price of a stock or market.

Over the years that has produced ranges of valuations for the market. Depending on the mood of the market, stocks can be overvalued or undervalued relative to the fair value. Yes, I said “mood.” The reality is that sometimes people are willing to pay a premium, while other times they prefer to sit on their money or only buy at a substantial discount. The actual value doesn’t matter in the moment. Sentiment does. It’s true of any product – whether that’s a TV, an ear of corn, or a stock. That’s where you get reversions to the mean (eventually the market will come back to fair value).

GMO is a company that does a lot of work regarding reversion to the mean. We have shown this chart before, but as I showed it to Andrew yesterday, he was shocked at how good certain parts of the 7-year forecast were, as the numbers have previously been quite grim for years now. Take a look.

You can see that according to GMO, US stocks are still overvalued, but outside the US, markets are much closer to historical valuations and, in some cases, quite undervalued. The last time we showed this, even expected returns on bonds were negative. One important thing to point out is this is “real return,” which takes into account inflation. If you assume 3%-4% inflation for 2023, you get 4%-5% expected returns for 2023 (I might argue there is upside to that).

All this is to say that the amount of earnings corporations realize in 2023 will likely drive market prices. If there are minimal downsides, that would say that the upcoming recession will be less severe and, in our opinion, much of the downside in the market would be factored in already. On the other hand, if earnings fall more than analysts assume, you would expect further weakness in the markets.

Let’s see what earnings season brings us and we will continue to adjust our thinking. If you have any questions, please reach out. Have a good week.