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Analysis | Corporate Earnings Move From Savior For Stocks To Nemesis

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The gains were supposed to bail out the US stock market, but they could prove to be bearish.

In the latest example of trouble, network equipment giant Cisco Systems Inc. Late Wednesday, he told investors that supply cuts will wipe out sales growth in the current quarter, and this week retailers Walmart Inc. and Target Corp. will contribute to the negative outlook revisions. The stock killings began, the broader market came under attack, and analysts began lowering their forecasts of where share prices could end this year.

According to Bloomberg data, 162 companies in the S&P 500 Index received target price cuts, compared to just 62 increases on Thursday. The difference marked one of the sharpest fluctuations in analyst sentiment in the series’ 11 years.

For months, market optimists have convinced themselves that earnings will bolster the stock market from the highest inflation in 40 years and rising interest rates. In their view, resilient consumer demand will keep sales strong, but few have relied on permanent supply chain confusion that could lead to empty shelves one month and an abundance the next. Now, analysts are reconsidering these assumptions, but they’re probably just getting started in earnest and haven’t even started to process the possibility of a full-blown recession.

If stock prices are essentially distilled into expected earnings and the multiples assigned to them (price-to-earnings ratio or P/E), then the first part of 2022 was mainly about P and the rest will focus on E.

Clearly, there is still a lot of room for downward adjustment of earnings expectations. S&P 500 earnings estimates compiled by Bloomberg still imply 10.1% adjusted earnings growth of around $227 per share in 2022. Even excluding energy stocks, which benefited from the rise in oil prices, estimates predict a 5.7% gain.

Most of the expected EPS growth is being restored for the remainder of the year, as DataTrek Research co-founder Nicholas Colas wrote on Thursday. Judging by the S&P 500’s 4% sell-off on Wednesday, its worst since June 2020, investors may be sensing the rottenness of those forecasts, but analysts aren’t there yet. “This story is falling apart,” Colas told me on Thursday. “Every cycle regression has symbolic days where the market takes the theme. And I think yesterday was one of those days.”

So how much will stocks actually drop? Colas suggests considering the “old Wall Street ’20 Rule”:

… which says inflation expectations plus the S&P PE ratio equals 20 over time. Current 10-year inflation expectations are 2.7 percent, making 17.3x the notional “fair value.”

Coincidentally, this is roughly the number of floors the market is trading today. Assuming Colas’ general rule is multiple and earnings are down 5% from run rates in the last two quarters, this would produce an S&P 500 value of 3,616, compared to a close of 3900.79 on Thursday, according to Colas’ calculations. Accordingly, one earnings drop:

In a typical recession, earnings are down 25%, Colas said, but you don’t have to imagine the worst-case scenario to see how stocks can go down from there. Of course, there are many other risks, including another wave of pandemics; Russia’s war in Ukraine; and the possibility that inflation will become so entrenched that it will not disperse even in an economic downturn – the nightmare stagflation scenario. What is clear is that earnings are no longer a valid excuse to stay positive about stocks. Without this pillow, the market could go very low.

More From Other Authors on Bloomberg Opinion:

• Stock Sales May Be Entering a New Stage: Mohamed A. El-Erian

• There’s a Horrible Smell of Symmetry in the Air: John Authers

• Credit Market Pain Is Too Silent to Save Stocks: Lisa Abramowicz

This column does not necessarily reflect the views of the editorial board or Bloomberg LP and its owners.

Jonathan Levin has worked as a Bloomberg journalist on finance, markets and M&A in Latin America and the US. Most recently, he served as the company’s Miami bureau chief. He is a CFA franchise holder.

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