Stocks Discounting Earnings Recovery

Joe Abbott & Ed Yardeni

The following excerpt is from Yardeni Research Morning Briefing?(May 23, 2023).

The stock market discounts earnings over the next 52 weeks. How do we know this? Most industry analysts provide earnings estimates for the current year and the coming year. They might provide earnings estimates or earnings growth forecasts beyond that period, but investors aren’t likely to have as much confidence in earnings forecasts beyond the next 52 weeks.?

Of course, industry analysts don’t forecast earnings on a 52-week-ahead basis. They forecast quarterly and total-year earnings for the current year and the coming year. However, forward earnings, which is the 52-week time-weighted average of the analysts’ consensus estimates for the current and coming year (updated weekly), is actually a very good leading indicator of actual earnings over the coming four quarters (Fig. 1 and Fig. 2).

Joe and I have the data for forward earnings monthly from September 1978 and the weekly data from March 1994. The monthly series divided by the CPI is a good leading indicator of the business cycle during economic expansions. Real forward earnings is a good coincident indicator of the business cycle during recessions (Fig. 3). It is highly correlated with both the Index of Leading Economic Indicators (especially during good times) and the Index of Coincident Economic Indicators (especially during bad times) (Fig. 4 and Fig. 5).

Industry analysts tend to be optimistic about their companies during economic expansions. Collectively, they don’t see recessions coming. When their companies confirm that a recession is underway, the analysts scramble to cut their earnings estimates.

Real forward earnings peaked at a record high during May 2022, falling 8.0% through April, which was the first month the series rose since the peak. It is still 17.5% above its pre-pandemic record high. Might April have been the bottom for real forward earnings? Joe and I think so because the weekly series for nominal forward earnings bottomed during the February 9 week and is up 1.8% since then through the May 18 week (Fig. 6). The weekly series for forward earnings (currently at $229.94 per share) is converging toward the analysts’ consensus earnings estimate for 2024 (currently $245.73), as always happens as a year progresses. Analysts’ consensus estimate for 2024 has been falling, but it remains well above their consensus for 2023 ($220.07). (We expect to be updating our earnings forecast in the next few days after the Q1-2023 results are compiled by Standard & Poor’s for the S&P 500.)

Real S&P 500 forward earnings was down 7.5% y/y through April (Fig. 7). We acknowledge that this sort of reading is consistent with early recession readings in the past. Nevertheless, if nominal and real forward earnings are bottoming now, that would be more consistent with our forecast of a mid-cycle slowdown, like the ones that occurred during the mid-1980s, mid-1990s, and from 2014-16.

In yesterday’s Morning Briefing, we observed that the Index of Leading Economic Indicators (LEI), which has been falling since February 2023, is biased toward the performance of the goods side of the economy. The 10 components don’t reflect the increasing importance of services. They tend to focus on the most cyclical sectors of the economy, particularly manufacturing and housing. Services in real GDP have tended to be less cyclical than goods in the past—with the notable exception of during the pandemic, of course.

Similarly, although S&P 500 forward earnings certainly gives plenty of weight to services, services providing companies in the index tend to be less cyclical than goods-producing ones. The usual relative stability of services earnings explains why the y/y growth rate of forward earnings closely tracks the goods-focused ISM manufacturing purchasing managers index (Fig. 8).

The same can be said about the S&P 500 forward earnings’ close relationships with the growth rates of business sales and industrial production (Fig. 9 and Fig. 10).

The goods side of the economy has been depressed since mid-2022 because consumers have pivoted from buying goods to purchasing services. So on balance, the economy has continued to grow, supported by services and defying the recession heralders.

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