In Jeff Mortimer’s latest Investment Update, he discusses how earnings recessions are used as a forecasting tool to reveal the direction of the economy.
We all know the feeling. With white knuckles and sweat on the brow, we wonder if we have studied the right material and have a deep enough understanding of the subject matter. But eventually, whether we are ready or not, test day comes. Armed only with our number 2 pencils, we sit down at our desks to be evaluated. I remember giving myself a pep talk before each test, hoping that my answers would reflect my hard work.
The stock market takes the “earnings test” every quarter like clockwork. It is a chance to evaluate price against results. The strength or weakness of this quarterly exam has been studied for decades, mainly because earnings season opens a window into assessing the health of the economy.
While recessions are officially determined by gross domestic product (GDP), the lagging nature of this data means that recessions are identified only after the fact. The same is not true for earnings, which are evaluated in real time. In addition, many of the same themes that cause earnings to go flat or decline, such as wage inflation and higher interest rates, also cause the overall economy to wobble. After all, the theory goes, if profits decline, job cuts can’t be far behind.
Earnings recessions are used as a forecasting tool, as many analysts see these results as an early, or coincident, indication of economic direction. Figure 1 shows the relationship of earnings recessions (defined by at least one quarter of negative growth on year-overyear earnings) to economic downturns. Many times an economy is already in a recession by the time an earnings recession hits, but the economic recession just hasn’t been identified yet. On average, the lag between the start of an economic recession and the start of an earnings recession is about seven months. History shows that earnings recessions last about five quarters, with earnings decreasing 15% on average from high to low.
But there’s a catch—economic recessions do not always coincide with earnings recessions. So in 2015, when second quarter earnings came in negative (year over year), it signaled to our Investment Strategy Committee (ISC) that a potential economic slowdown or recession could be on the horizon. At that time, we had 50 years of data showing that an economic recession followed an earnings recession six out of nine times. It was our job to determine where this earnings recession would lead.
Digging deeper under the surface, it became clear to us that the energy sector was the major contributor to the earnings shortfall, just as it was during the 1985 earnings recession. We also noted that the 1985 earnings recession was not followed by an economic recession, possibly because it was caused by a fall in the price of energy. We determined that while the energy sector would suffer in the short term, the impact of lower oil prices on input costs would be an overall benefit to the economy.
As such, we continued to position investment portfolios for a continued, but slow, recovery. So far, positive year-over-year earnings for the last couple of quarters have affirmed that prediction. The question now is what comes next?
Many studies have tried to determine how markets behave during different earnings trajectories. And here, intuition is correct. Over the past 30 years, during periods of rising year-over-year quarterly earnings, Leuthold Group shows that the market has risen by 12.1%, versus returns of 3.9% when quarterly earnings are declining.
So what should we expect from earnings going forward as we continue to distance ourselves from this last earnings recession? One metric I look to is the Institute for Supply Management (ISM) Purchasing Managers’ Index (PMI) reading. Figure 2 shows the ISM data shifted forward six months versus the trailing 12-month earnings growth rate. PMI readings above 50 are deemed to be expansionary and correspond nicely to cycles of earnings growth. The recent PMI reading above 50 bodes well for earnings for at least the next six months, in line with our expectations for earnings growth to remain strong.
Other work by Gail Dudack of Dudack Research shows that earnings cycles tend to gain a second wind of momentum 108 months (nine years) after the previous economic peak. In this cycle, that would correspond to a November 2016 time frame for earnings growth to begin to gain momentum. This longer-term study dovetails nicely with the ISM data.
These factors indicate that earnings should be moving higher in the quarters ahead, which should be good for stocks and signal that the economy is in decent shape.
In studying past earnings recessions that ended without an economic recession, I noticed that risk assets performed best. It is as if the market is relieved, and that leads investors to add risk into their portfolios. In particular, asset classes like small capitalization stocks and emerging market equities have shown a history of performing well near the end of most earnings recessions. And since the most recent earnings recession ended in September 2016, the ISC has been shifting allocations to these two asset classes.
Earnings slowdowns are disconcerting. But being well prepared and having the proper perspective allowed us to remain invested in equities during the latest earnings soft patch and reap the benefits of the recovery in asset prices that has followed. We have even been able to lean in and add exposure as markets rallied. In the midst of another very important earnings season, it appears profits will be able to pass their latest test.
This material is provided for illustrative/educational purposes only. This material is not intended to constitute investment or financial advice. Effort has been made to ensure that the material presented herein is accurate at the time of publication. However, this material is not intended to be a full and exhaustive explanation of all of the investment or financial options available. The information discussed herein may not be applicable to or appropriate for every investor and should be used only after consultation with professionals who have reviewed your specific situation.
BNY Mellon Wealth Management conducts business through various operating subsidiaries of The Bank of New York Mellon Corporation.
©2017 The Bank of New York Mellon Corporation. All rights reserved.
Director of Investment Strategy, BNY Mellon Wealth Management
Jeff Mortimer is the director of investment strategy for BNY Mellon Wealth Management. In this role, he leads a team that sets capital market expectations and is responsible for making asset allocation recommendations. Jeff has more than 25 years of experience in the financial services industry.View Profile