Where will the S&P500 go in 2023?

Anyone who knows me knows I’ve been pounding the table on an earnings recession for the last 3 months. I was beginning to sound like a broken record. And now it’s here and the whole world is talking about it. Well, at least Morgan Stanley is.

The thing with Macro and Fundamentals is that they always take time to play out. Things don’t happen overnight but, when they do… we see a lot of things breaking.

And this always remind me of one of my favorite quotes from Ernest Hemingway’s The Sun Also Rises:

So, what is an earnings recession?

Much like it sounds. An earnings recession in two consecutive quarters of negative earnings growth. As we stand, the blended earnings growth for the S&P is now -5.3% from -5% last week, according to Fact Set.

So we’re definitely experiencing a sequential decline in the growth and the projected earnings growth for Q1, 2023 is now -4.7%, and this is with the enormous increase in earnings coming out from the Energy Sector.

And guess what? It doesn’t stop there. The quarter after that is also projected to have negative growth albeit smaller at -2.99%.

This is the fifth time in history since 2000 that forward earnings growth has turned negative, according to Morgan Stanley. ⤵

What’s Driving the Earnings Recession?

The macro.

I’m quite sure that you will hear people out there who say that macro doesn’t matter. And for someone like Buffett, perhaps it doesn’t. But, I also remember the meeting that Buffett decided to bring in Paul Samuelson’s economics book to the party. So yes, if you’re holding stocks through multiple macro cycles, there’s somewhat of a case to be made here. But, even then the macro can dictate when to buy and with stocks heading to a low soon enough, that will be the time to pile in.

The Fed took it upon itself to finally do something about inflation getting out of hand, well after it had already gotten out of hand. It’s no secret that they pumped this market full of cash and made borrowing so cheap that it was a joke. The consequence was a bubble like we’ve never seen. And as much as we’d like to think that supply chain drove inflation, it was not the only factor. That just added fuel to the fire.

And so now we have a situation where the Fed is raising the cost of capital and vacuuming money out of the system and with that they are destroying demand.

Look at the data. This is one my favorite charts from December and it clearly shows that as the Central Bank balance sheets exploded, so did revenue per share for companies. So what do you think happens, when the balance sheet starts shrink? Revenues will also shrink. ⤵

But, let’s not forget the cost of capital. Where does that hit? That hits the bottom line, i.e., earnings. As the Fed increases rates and makes it more expensive for everyone to borrow, people and companies get hit with a large interest bill.

I know the data on the S&P500 looks decent and bond maturities (corporate debt) has been pushed out to 2026-2027. If you look at the interest coverage, i.e., how many times their earnings can cover interest payments - that is also decent at about 9x. This means the S&P500 companies can cover their debt 9 times. That’s quite high.

But, the S&P is not the market and we have other companies that have issued debt. There are three issues to consider here

1. Most smaller companies take debt from banks on floating rates of interest, i.e., their interest rates are not fixed. So as the Fed Funds Rate goes up so does their interest expense.

2. Secondly, we have maturities coming up all along the way, as you can see below. When bonds come due, it’s usually the case that they are refinanced and in this case companies will be paying a higher rate.

3. Finally, we have a situation where we don’t have enough cash in the system. If you remember the chart on money supply from Mayhem’s previous article, you’ll remember that we are in negative money supply growth now. So, there may not be enough cash in the system to actually repay this debt or the interest on it.

Finally, we have inflation.

What Happens when Inflation starts to decline?

When inflation starts to decline, it also means demand starts to decline. Companies with pricing power will need to eventually reverse their stance. This will play out into margin compression - sales prices coming down and costs going up - both due to higher labor costs and higher cost of capital. This is likely to lead to a deeper earnings recession.

If you look at the chart below, I’ve indexed the next twelve months of EPS (Blue) and Sales Per Share growth (Green) for the S&P500, to make them comparable. The purple line is YoY Inflation growth.

You can see the clear divergence forming between Sales and Earnings, with Sales being higher and Earnings going lower. This widening gap means that margins are getting smaller. If you look at the inflation data for the last two years and in prior historical periods, the gap tends to widen during declining phases of inflation (i.e., margin compression).

Oh but wait, I said something completely different on Fox Business - but that was for consumer staples. With consumer staples, prices remain sticky to the upside, i.e., because these are everyday necessities, prices are not immediately reduced and with input costs coming down, the margins tend to expand. We also see some of this in health care and utilities, which is why these sectors tend to do relatively better in a recession. But, this can’t go on forever, and eventually everything declines in a recession.

What does this mean for the Market?

Historical data is quite clear. An earnings recession almost always leads to a recession, which also leads to a decline in the S&P 500.

The Chart below shows achieved EPS Growth (blue), achieved sales growth (green), US GDP growth (purple) and the S&P500 (gray).

There are a few observations to take away from this: 

1. Earnings go negative quite early into a recession

2. A recession can start with a positive quarter but as earnings turn more negative so does GDP

3. The relationship between earnings growth, and the market is tenuous. It’s not very clear and the market may not even bottom during a recession.

In 2001, earnings bottomed prior to the market bottom and recession also ended before the market hit bottom.

In 2008-2009, the market bottomed before earnings and during the recession.

Whichever way you want to look at it, earnings haven’t bottomed. I realize that the forecast is for a lower decline in earnings for Q1, 2023 but I don’t think this will be the case. I believe we still have further to go in terms of earnings declining. And if that’s the case, we have not seen the market bottom as yet. 

My Price Target on the S&P

Everyone’s putting out a Price Target on the S&P and I thought I’d do some math as well. While I’m a fundamental analyst, my earnings estimates are heavily influenced by the macro situation.

I’ve taken into consideration:

Past earnings decline during recessions 

The Average Price-Earnings Ratio (P/E) for the S&P 500

According to the estimates, my worst case earnings per share is $190 which is -13.6% below the 2022 numbers (estimated). With the 25-year average P/E of 16.8x, my level for the SPX comes out to $3,192.

Based on intrinsic value calculation, the average value under different scenarios is $3,412. If you ask me, I would pick $3282 being the most probable.

Closing Thoughts

There’s no place to hide in a recession where stocks are concerned. But, we will still find corners of the market that will do less bad and that where we need to focus our efforts. We will also see some companies withstand the pressure and those will be the names to buy.

So the bottom in the stock market is coming, it’s just not yet.