What Did We Learn This Week? (10/06/2022)—Sell-side Research

Prior to joining WealthVest earlier this year, I spent the better part of the last decade as a manager in Sell-side equity research departments. It is in these departments where the bottoms-up forecasts for S&P earnings originate. I often hear pundits on CNBC or Bloomberg recommending the buying of stocks by making the argument that the market is cheap based on forward earnings estimates. These are the pundits you want to avoid. They don’t know, nor do I, where earnings are going to shake out so they are applying a multiple to a number in which they should have no confidence. Garbage data in, garbage out.

The bottoms-up forecast for S&P earnings in 2023 is around $240. That would put the current forward multiple on the S&P 500® at roughly 15.3, not a bad multiple over recent decades to have added market exposure. The bottoms-up forecast is arrived at by taking the average forecast of all the Wall Street analysts that cover each company in the index and adding them together. This can be a reliable number in bull markets and historically even tends to come in lower than eventual reported earnings. However, in a tightening cycle and in an economic slowdown like we are now experiencing the number should be disregarded entirely.

The vast majority of companies in the S&P 500® offer forward earnings guidance. By and large, analysts take that guidance, after getting more granular data in on-on-one conversations with the companies, and plug that into their models. Not surprisingly, the analysts will all have earnings expectations that are in-line with the guide, but with small tweaks that will put them a couple pennies above the street if they have a Buy recommendation or maybe inline or a penny below if they have a Sell or Neutral rating. Sell ratings and estimates way below guidance are rare. That’s because Wall Street research departments are funded in large part by investment banking. Banking has zero interest in paying analysts to have Sell recommendations on stocks since it likely means that collecting fees from that client via underwriting or advisory work is going to be prohibitively difficult.  

The result of this dynamic is that analysts are loathe to put Sell ratings on stocks or to have earnings estimates well below consensus. To do so is an unambiguous career risk. In an upward trending economy and market, this isn’t as big of a problem as it is in a down market. Banking’s influence on equity research problematically manifests in times like now when demand is clearly decelerating or declining and analysts, instead of being proactive, will choose to wait until a company’s next earnings report and guide to take down numbers. Consensus estimates will always lag real earnings power on the way down. The issue is structural.

It is also rare to see a company guide to a weaker economic environment than what they are currently experiencing. We all know that monetary policy and higher interest rates manifest with “long and variable lags”, but that isn’t how companies guide. As someone who has listened to myriad quarterly conference calls, I can honestly say that I have never heard a management say anything along the lines of: trends remain solid but we expect a more difficult demand environment and based on our macro view, we are going to lower guidance.

We are at all-time high margins for the S&P 500®. We are annualizing demand that was artificially inflated by emergency monetary and fiscal largesse. The Fed has raised rates by 300 basis points and will likely raise by at least 100 more by year-end. More than 40% of S&P earnings are international as the US Dollar screams higher which means that every time you get paid in Euro’s or Yuan, you are getting significantly less that you were a year or even six months ago. Europe is heading into what will likely be a deep recession and we have yet to see the much anticipated demand recovery in China and South Korea, but with all that said, consensus earnings expectations are still 10% higher next year. That’s nonsense. In fairness, inflation can be a tailwind for corporate earnings as they tend to pass through prices above the cost increases and of course earnings are expressed in nominal terms. But it is also undeniable, that as company’s revenues decelerate or decline, profitability de-levers as capacity utilization falls.

Recessions historically see earnings estimates fall at least 20% from peak to trough. I have no idea if this one will be a deep or shallow recession but I know it will be global and I know that we are coming off an ebullient peak.  According to a recent KPMG survey, over 80% of global CEO’s expect a recession over the next 12 months, but don’t expect guidance to reflect that. Nominal growth remains strong in the US so I think we are likely to see another earnings season that comes in not as bad as the bears expect and while guidance will push estimates lower, you should not expect to see guidance to collapse. Downward revisions will grind lower over the coming quarters and there will be no “all-clear” signal that the declining market earnings power has bottomed. Be patient. De-risk opportunistically as sharp rallies are a feature of every bear market.

For more on from Tim, follow his podcast The Weekly Bull and Bear wherever you listen to your podcast or read his weekly blog posts here.

Tim Pierotti is WealthVest’s Chief Investment Strategist. 

Tim has over 25 years of experience in various aspects of the equities business. Prior to joining WealthVest, Mr. Pierotti spent seven years in Equity Research management roles at Deutsche Bank and most recently at BMO where he was a Managing Director and Head of US Product Management. Tim has 11 years of investment experience most notably as Head of Consumer Research and Portfolio Manager at The Galleon Group, a former NY based $8Bln Long/Short hedge fund. Tim is a graduate of Boston College and lives in Summit NJ.

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