In brief

• 2Q22 revenue beats are tracking above their long-run average, while earnings beats are tracking below
• The U.S. economy is losing momentum, but the stock market seems to have priced at least some of this in
• Equity volatility looks set to persist as long as interest rate volatility remains elevated

As of writing, with around 91.4% of S&P 500 market capitalization reporting, we are currently tracking U.S. earnings per share of USD 47.09 for the second quarter. 70% of companies have beaten earnings estimates while 63% have beaten revenue estimates. Revenue beats are tracking above their long-run average, while earnings beats are tracking below. In a similar vein, revenue surprises have been larger than average, while earnings surprises have been below average.

The end of the earnings season has seen aggregate earnings estimates deteriorate due to write-downs, which is reminiscent of 2015/2016 when a significant and sustained gap emerged between operating and pro forma earnings. These write-downs show up in margin weakness and account for the full percentage point decline in margins this week. In the event, many investors have been asking us which earnings they should look at. The market prices off of pro forma earnings, but adjustments can make it more difficult to compare current earnings to prior periods.

While we understand the thinking behind some of the pro forma adjustments, we prefer to measure corporate profits using operating earnings, as not all of the adjustments being made seem appropriate.

The question for investors, however, is which measure of earnings has the highest correlation with stock market returns. Based on data since 2001, pro forma earnings have the highest correlation. That said, the data is extremely skewed by the fact that operating earnings turned negative in 4Q08. If this data is excluded, operating earnings exhibit the highest correlation. This dynamic, coupled with the fact that there is a far longer time series available, suggest operating earnings are the best measure for long-term investors to use when attempting to gauge corporate profitability.

Much ink has been spilled about the risk of recession rising in the U.S. and around the world, but what does an economic accident mean for equities? Markets are forward-looking and have historically seen performance turn around before the economic data troughs.

Exhibit 1: Equity and unemployment performance during previous recessions

Source: BEA, BLS, FactSet, NBER, J.P. Morgan Asset Management. Data are as of August 8, 2022. 

In the table above, we looked at the relationship between the S&P 500, unemployment rate, and gross domestic product growth around recession. Unemployment, on average, tends to bottom nine months prior to the start of a recession. Unemployment hit 3.5% in July 2022, suggesting that recession could potentially begin in March 2023.

We then calculated how long it has historically taken for a recession to begin after the S&P 500 hits a low. On average, it has taken seven months. The current market low was on June 16, 2022, so according to this theory, the market is pricing a recession that starts in December 2022/January 2023. We then calculated the drawdown from the 12-month prior low to the recessionary period low. On average, the S&P 500 has declined an additional 14.4% from its 12-month low prior to the recession. Although this is skewed by the financial crisis, it does suggest that there may be room for equities to move lower after a strong July.

The bottom line is that recession risks are rising and markets are in the process of pricing this in. At the same time, however, forward earnings estimates are still too high, leading some to believe that markets could see a significant decline as profit forecasts are revised lower. We would agree that current estimates are too high and will need to come down in the coming weeks.

As earnings expectations decline, what will this mean for returns? 2022 has been characterized by a significant decline in valuations against a backdrop where earnings expectations have remained resilient. Will both earnings and multiples decline in 2023? That would very much be the exception to the rule. In only 8 of 111 past calendar years have we seen both forward price-to-earnings ratios and earnings expectations simultaneously drag on annual returns. Furthermore, if the assessment above is correct, one could expect multiples to drive a relief rally as markets look to the other side of the recession.

Investment implications

Two negative quarters of growth do not technically represent a recession, but U.S. growth has clearly decelerated over the first half of this year. Part of this has to do with higher commodity prices, but part of it has to do with higher rates. The bottom line is that the U.S. economy is losing momentum, but the stock market seems to have priced at least some of this in.

With the Federal Reserve (Fed) continuing to tighten, earnings are key. We prefer sectors with operating leverage—materials, energy and consumer staples, but also structural growth stories like technology and healthcare, which are looking more attractively valued following the sell-off seen during the first half of the year. Equity volatility looks set to persist as long as interest rate volatility remains elevated. Bringing down rate volatility will require more clarity on inflation and the Fed, and the coming weeks will begin to provide us with the information we need.

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