Who will weather the storm?

A look at the quarter ahead and what we should be doing

Earnings season should be brutal this time around. That doesn’t necessarily mean that stocks will tank to zero. We’ve seen several instances in the last few quarters where companies have beat estimates and gone on to rally.

We’re in a difficult situation. Estimates are all over the place. In some cases, they are too conservative and in other not conservative enough. We’re held hostage to analysts who have never seen this part of the cycle. And what’s worse is with the amount access to information we all have, no one wants to stick their neck out too far.

What is this part of the cycle anyway?

What we have today is a macro environment that is a mix of several different time periods in history. So, there’s no one view that will fit what we’re experiencing. Add to that the rise of new trading “methods”, for lack of a better word. We have the highest number of retail traders in history, and we have new ways to “game” the market through 0DTEs (options with zero days to expiry).

So, we’re seeing a major disconnect.

Bubbles are infamous for causing a disconnect from reality. This time though the disconnect persists even though we’re seeing the bubble deflate. Stock prices are yet to catch up with the fundamentals.

In many cases, company guidance is making matters worse. Companies have reported poor results but a positive guidance sends the stock price flying. Who’s to say that they know how to risk manage this macro environment, either. The truth is most of us remember nothing but the last 15 years of easy money.

Whether price leaps on earnings or guidance, the problem with these movements is that they’re temporary. We almost always see the prices come back down to earth or in the opposite situation recover from a gap down.

What we should be looking at is the sequential decline in the results - whether revenues or earnings, or even in many cases margins. But, this is hard work and sometimes, we just want to play what’s in front of us. And I say play, because that’s exactly what we’re doing. Chasing price to make a quick return.

But, if I’m right we’re going to see some tough earnings this time. This quarter’s sequential decline will seal the deal on the earnings recession. This is likely to pull the economy into a recession as well. We have a whole host of economic factors that point to the same consequence.

But is an earnings recession necessarily a bad thing?

I know recessions mean doom and gloom and an earnings recession likely means the same negative scenario for stock prices and ultimately the market.

The earnings per share on the S&P 500 is currently $216.04 (FY 2022) and the projected earnings is still $219.75. As of 30 Dec 2022, the S&P 500 closed at 3839, giving us a P/E of 17.77x. The 25-year historical average P/E is 16.82x. If you consider that these earnings are still too high, we have more room to the downside.

$3192 on the SPX was my estimate based on the average P/E that I put out at the beginning of the year on Macrovisor. My estimate based on Discounted Cash Flows was $3412.

But perhaps this reset is what we needed.

We’ve just experienced the greatest bull market in history. The S&P went from $2191 during the Covid Lows to its peak at $4818 on 04 Jan 2022. That’s an increase of almost 120%!

This was partly driven by:

• Era of low rates - Borrowing for Stock Buybacks and everything else under the sun

• Liquidity - More revenues; more speculative investments; overpaying for acquisitions (this will lead to higher goodwill write downs)

So, the reversal of these issues will probably bring companies down to reality. A reality where 100x P/E is not the new normal. It will force us to scrutinize stocks and look out for red flags, because we know that stocks don’t always go up.

Take for example, Micron MU 0.00%↑

Revenues have halved in the last 2 quarters. At this run rate they are likely to reach $15.5B in revenues for the year compared to $30.7B in the previous year. Does this mean it’s a bad company? By no means. But it means that Micron has stopped riding the train of easy money and there is some re-rating required.

But you know what? Micron is trading at $58.51. If someone told you in 2002 that Micron would reach $7 or so, you would be laughed out of the room. The recession was technically over by 03 Dec 2001 and yet… it did.

So, if we think that these prices can’t go any lower, think again.

Micron 30-year price chart; Source: FactSet

What does the overall Macro Picture tell us?

We know what the Macro picture is telling us. Things are not looking great. If you remember my colorful chart on the manufacturing data from the last week’s article on the Industrials, we know that a recession isn’t a far-fetched idea. Walmart and McDonald’s are letting employees go - that should settle the debate.

The question is, however, what happens to stocks. Most of us think stocks bottom during a recession. Well, that was the case for 2008-2009 but not for 2000-2001.

30-year Price Chart; Source: FactSet

The truth is we don’t know when the market will bottom. And waiting around to catch that low is perhaps not the best thing to do. But what is a good idea is to actually look at these companies now from a fundamental perspective.

I think this earnings season will likely show us results where a lot of the fluff has come off from companies. This will mean that we can start to look at the numbers for what they are. This quarter will be a great time to for us to look at these companies in more detail and make a shopping list to buy some strong names that are likely to weather the storm in the next few years.

I like to say there’s always a story behind the numbers… but that doesn’t mean we look at only the stories and not the numbers. I know that price action these days seem to render fundamental study meaningless but, trust me there’s still value in looking at the numbers.

This is time when we match the two and try to reconcile the picture.

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None of the above is Investment Advice. I may or may not have positions in any of the stocks or asset classes mentioned. I have no affiliation with any of the companies other than explicitly mentioned.

Full disclaimer: https://ayeshatariq.substack.com/about