The Big Picture

Column summary:

1. Earnings estimates decline in a recession.
2. The depth and/or duration of any recession will ultimately dictate how bad an earnings decline will be.
3. Portfolio adjustments can mitigate recession risks.

Recessions are part of the business cycle. Fortunately, they do not happen often, but when they happen, they hurt in more ways than one. People lose their jobs, credit defaults increase, businesses suffer as customers spend less, loans are harder to get, and stock prices take a hit.

Why do stock prices take a hit?

• Earnings contract and earnings estimates get cut.
• Investors refocus efforts on preserving capital versus the traditional pursuit of seeking a return on capital.
• Emotional selling, driven by the fear of suffering additional losses, takes root.
• Margin calls happen as stock prices slide, triggering forced sales for overleveraged investors unable to meet margin loan requirements.
• Investor confidence is shaken, resulting in fewer buyers and more sellers.

The main item at the root of it all, though, is that first item: earnings contract and earnings estimates get cut. 

Some Brutal Episodes

Not all recessions are the same.

The Great Recession of December 2007 to June 2009 (sparked by the financial crisis) was brutal. It lasted 18 months, housing prices plummeted, the unemployment rate spiked to 10%, and the S&P 500 declined as much as 57%.

The COVID recession was also brutal. The unemployment rate spiked to 14.8% and the S&P 500 declined as much as 32%. The remarkable thing about the COVID recession, though, is that it lasted just two months (February 2020 to April 2020) in NBER Business Cycle dating terms thanks to the massive fiscal and monetary policy stimulus implemented by Congress and the Federal Reserve. The psychological and economic effects of that recession, however, lasted a lot longer than two months.

Still, with the U.S. economy and global economy effectively grinding to a halt in early 2020, one can imagine how that quickly changed the earnings outlook. You can see that in the chart below.

The forward 12-month EPS estimate, which stood at $175.00 on January 20, 2020, dropped to $138.48 as of May 15, 2020. That is a 20.9% decline. The average peak-to-trough earnings drop in a recession since 1960 has been about 31%, according to Yale University Professor Robert Shiller's data.

In one sense, then, the COVID recession wasn't nearly as bad as the Great Recession, but it was worse than the recession associated with the dot-com bust and 9/11.

Recession Talk in the Air

Lately, there has been a lot of talk about the U.S. economy facing the risk of a recession. That narrative has picked up with the inversion of the 3-month T-bill yield and the 10-year Treasury note yield, the arrival of some disappointing economic reports signaling some weakness in consumer spending and consumer confidence, and of course the cloud of uncertainty swirling around tariff and counter-tariff actions.

The price action in the stock market has exacerbated the recession worries, partly because it has featured the outperformance of the counter-cyclical sectors and partly because of the reduced wealth effect tied to the roughly $5 trillion decline in the S&P 500 market cap. 

The S&P 500 has declined as much as 10.5% since hitting an all-time high on February 19. The Nasdaq has dropped as much as 14.7% from the all-time high it reached in December, and the Russell 2000 has declined as much as 19.5% from the all-time high it hit in November.

You wouldn't have any inkling that the 'R' word was even being mentioned, however, when looking at the forward 12-month EPS estimate. In the same time the S&P 500 has declined more than 10%, the forward 12-month EPS estimate has increased 1.0% to $277.08, according to FactSet. Given that, the forward 12-month P/E multiple has contracted to 20.3x from 22.4x.

So, how bad could a recession be?

First, there has to be one, and secondly, the depth and/or duration of any recession will ultimately dictate how bad an earnings decline will be. In modern times, the Great Recession stemming from the financial crisis is about as bad as it gets from both a depth and duration standpoint; we saw a 35.3% cut in the earnings estimate during that period. The COVID recession was worse in terms of its depth but not anywhere close in terms of its duration.

The current forward 12-month estimate isn't taking any recession risk into account, which is why it can be said that there is a lot of downside risk in it if a recession were to come to fruition.

Using the last three recessions as an approximate guide for the scope of estimate declines, we can approximate what the S&P 500 price risk might be based on a range of average historical multiples -- 5yr (19.8), 10yr (18.3), 20yr (16.2), and 25yr (16.7). The S&P 500 is currently trading at 5,630.

• A 14% cut to the EPS estimate

•  A 21% cut to the EPS estimate

• A 35% cut to the EPS estimate

Briefing Analysis

The recent sell-off in the stock market hasn't felt good. It has happened quickly, not in a fearful kind of way but in a recalibration kind of way. Valuations were stretched, economic news was mostly disappointing, tariff actions cranked up, and a market hitting all-time highs roughly four weeks ago, and savoring the idea of tax cuts and deregulation, was suddenly hearing voices about a possible recession.

It may ultimately turn out to be nothing more than voices in the market's head, but if nothing else, the recession narrative has fostered the reminder that nothing good happens in terms of earnings estimates when a recession hits.

We have some historical guidelines for earnings estimate trends in prior recessions, but each recession is different. There is no recession today and there may not be a recession anytime soon --  or perhaps there will be. The market will sniff it out and price it in long before the NBER will slap a date on it.

This bull market has clearly been disrupted by the idea of a growth slowdown that could turn into something more. If you want to insulate your investment portfolio for a growth slowdown or a recession, here are several ways to do so:

• Add exposure to countercyclical sectors like health care, consumer staples, and utilities.
• Lean more on stocks of high-quality companies that have a sound financial position and a history of regularly increasing their dividend.
• Preserve capital while generating income with the purchase of government bonds and investment-grade corporate bonds.
• Allocate some money to alternative investments like precious metals.
• Tamp down individual stock risk with the purchase of mutual funds and or ETFs.
• Raise some cash to deploy in the event of a material downturn in the market.

Nobody likes the idea of a recession, but they are part of the business cycle. In the same vein, a downward revision to earnings estimates is part of a recession experience. How that translates into stock prices will have a lot to do with the severity of the recession. There isn't a recession embedded in the current earnings estimate, yet the stock market is seemingly bracing for a disruption of some kind to the estimate trend. Accordingly, stock prices have taken a hit.

--Patrick J. O'Hare, Briefing.com