The earnings recession is a heavy weight on stocks
On the surface, the economy and the stock market seem just fine. Quiet maybe. But after the harrowing volatility in January and February, that's a comforting change as the Dow Jones industrials index continues to flirt with the 18,000 level. That's what it has been doing for the last three months -- capping a three-year courtship with that psychologically important level.
To be sure, reasons for optimism abound. The housing market is strong. Job gains are steady. And according to LPL Financial and most other economists, the chance of an economic recession in the near future is limited, despite the Federal Reserve's monetary policy tightening bias.
Yet a different kind of recession, an earnings recession, is already underway, and it could continue weighing on stock prices as valuations become more and more trying amid falling corporate profitability.
The first-quarter earnings season is largely behind us now. According to FactSet, with 98 percent of S&P 500 companies reporting, the blended earnings growth rate is -6.7 percent -- the fourth consecutive quarter of falling earnings. This is the first such four-quarter stretch since 2008-2009.
While official economic recessions are benchmarked by the National Bureau of Economic Research, the quick-and-dirty rule is two consecutive quarters of negative GDP growth. By this metric, the U.S. is well into a profits recession.
Fueling the drop has largely been a collapse in energy revenues as oil prices cratered from their summer 2014 highs. The latest year-over-year growth rate for energy sector earnings stands at nearly -67 percent, marking the sixth consecutive quarter of falling profitability.
But the weakness isn't isolated: Three other sectors are suffering declining earnings: financials, materials and consumer staples.
Earnings recessions like these aren't infrequent: 12 have occurred since 1954. But they often suggest underlying weakness in the economy at large because nine happened within one year of an economic recession.
On average, earnings recessions have lasted a little more than six quarters, with a maximum year-over-year drop in S&P 500 profits of 17 percent (vs. 4.1 percent now on a trailing 12-month basis). Yet, as LPL Financial noted, longevity of earnings declines shows lots of variability, from 11 quarters in 1990 to just two in 1981.
The impact on the stock market also varies greatly, from drops of more than 50 percent following the 2001 and 2007 earnings recessions to just 6.6 percent in 1967. The current profit decline has posted a max drawdown of 14.2 percent, of which the vast majority has been recovered.
Whether we've seen the worst -- in terms of both earnings weakness and risk to stock prices -- depends on the path of the U.S. dollar and if an economic recession materializes. Societe Generale noted that much of the drag on U.S. earnings has come from a strong U.S. dollar, a dynamic that could continue if the Fed hikes interest rates more aggressively than the market expects.
Moreover, earnings recessions accompanied by an economic recession averaged a maximum stock market decline of nearly 30 percent vs. just 8 percent for earnings recessions alone.
But even assuming the Fed carefully manages its tightening campaign and the economy keeps chugging along, investors need to stay cautious: The 1985 earnings recession scenario is unique, lasting seven quarters but featuring a 33 percent market drop the following year -- including the Oct. 19, 1987, Black Monday crash -- with no accompanying economic recession.