How Does The Bottoming Process For Stocks Start?

Articles From: Invesco US
Website: Invesco US

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Investment Strategist

Key takeaways

Bonds

The bottoming process for stocks typically starts at the top of the capital structure with a rally in government bonds.

Valuations

A lower discount rate usually helps the price-to-earnings (P/E) ratio to stabilize.

Earnings

Deteriorating fundamentals should kick multiple expansion into overdrive.

Since April, I’ve acknowledged the rising risks to the stock market and earnings outlook. While hindsight is 20/20, it was clearly appropriate to be bearish on stocks through the entire first half of the year. That said, I believe those negative themes may have largely matured.

In recent weeks, I’ve been vocal about the cyclical bottoming process for stocks, a sequence that typically begins at the top of the capital structure with a rally in government bonds. Indeed, a lower discount rate usually helps the P/E ratio to stabilize, as was the case in the stock market recovery of 2020 (Figure 1).

Figure 1. Is the bulk of the stock market contraction behind us?

Figure 1. Is the bulk of the stock market contraction behind us?

Sources: Bloomberg L.P., FRED, Standard & Poor’s, Invesco, 8/1/22. Notes: NBER = National Bureau of Economic Research. Shaded areas denote NBER-defined US recessions. Trailing 12-month = A rolling sum of the past year of historical earnings per share (EPS). Operating EPS = Income from products (goods and services), excluding corporate (M&A, financing, layoffs) and unusual items. P/E = Price-to-earnings ratio or earnings multiple. An investment cannot be made in an index. Past performance does not guarantee future results.

In my view, the bullish case – which I’ve dubbed an “immaculate” disinflation – and strong surge in stocks off their June low are predicated on the following chain of positive events that I laid out in May.

Signposts on the roadmap to “recovery 2.0:”

  1. Stagnating economic activity – check
  2. Lower oil prices – check
  3. Easing supply chain disruptions – check
  4. Peaking inflation – signs of hope
  5. Maximum Federal Reserve (Fed) hawkishness – ?

Despite my bearish apprehension at the time, even I could see a path out of our collectively grim situation, as challenging as it has been.

Isn’t the Fed inducing an earnings recession?

Company reporting is largely complete, and S&P 500 trailing four-quarter operating earnings per share (EPS) seem to have grown 20% year-over-year (y/y) in the second quarter of 2022.1

True, that’s a sharp deceleration from peak earnings growth of 70% y/y in the fourth quarter of 2021.1

However, the information content is lacking as we’re already approaching the fourth quarter of 2022. Moreover, market cycles lead business cycles, not the other way around.

Judging by the double-digit drawdown in stocks during the first half of this year and recent declines in leading indicators of manufacturing activity, I still expect an earnings recession at the end of 2022, heading into 2023 (Figure 2).

Figure 2. US policymakers are trying to restrain an overheating economy.

Figure 2. US policymakers are trying to restrain an overheating economy.

Sources: Bloomberg L.P., Institute for Supply Management, Standard & Poor’s, Invesco, 8/1/22. Notes: ISM = Institute for Supply Management. The ISM Manufacturing New Orders Index is a direct measure of expectations captured by business surveys of order placement and demand. Diffusion indices have the properties of leading indicators and are convenient summary measures showing the prevailing direction and scope of change. An investment cannot be made in an index. Past performance does not guarantee future results. There is no guarantee that estimates/forecasts will come to pass.

Unfortunately, investors probably won’t hear about the fundamental weakness from companies directly until the 1Q23 reporting period, which doesn’t start until the second quarter of next year! That’s the futility of obsessing over earnings season – it provides stale information that doesn’t aid investors in getting ahead of stocks in real time.

What happened to valuations and earnings in past recessions?

Mark Twain is reputed to have said, “History doesn’t repeat itself, but it often rhymes.”

Despite my disdain for poring over the latest company earnings releases, I do believe that past market cycles can be instructive. If history is a guide, the good news is that an earnings recession would likely kick multiple expansion into overdrive.

From the beginning to the end of the early 1990s, early 2000s, late 2000s and early 2020s recessions, earnings contracted 6%-52% and P/E ratios expanded 6%-30%. From my lens, it appears that the 7% earnings decline in 2020 was most reminiscent of the early 1990s experience, and a similar fundamental performance seems reasonable this time around (Figure 3).

Figure 3. Earnings fell and P/E ratios rose during each of the last 4 recessions.

Figure 3. Earnings fell and P/E ratios rose during each of the last 4 recessions.

Sources: Bloomberg L.P., Standard & Poor’s, Invesco, 8/1/22. Notes: According to the NBER, the last four economic recessions occurred from February to April 2020, from December 2007 to June 2009, March to November 2001, and from July 1990 to March 1991. An investment cannot be made in an index. Past performance does not guarantee future results.

Why do multiples expand during recessions? One explanation is that it’s a denominator effect. When earnings (E) fall, they cause the P/E ratio to rise.

Another explanation is that stocks, which are leading indicators of business activity, anticipate corporate profits by 3-6 months. Near major lows in the business cycle, stock prices (P) tend to look across the valley to better times ahead.

What about the bearish case for stocks?

Admittedly, the lack of fear in the marketplace, blood in the streets and major credit event of the cycle all but robbed me of a high degree of tactical conviction in the stock market rally that occurred off the June lows.

As I expected, stocks have been pulling back from overbought extremes at a time in the calendar year that’s generally known for its seasonal weakness.

Indeed, I think that an ongoing period of consolidation – to keep digesting the gains that we enjoyed over the past couple of months – would be a realistic near-term expectation.

From my lens, however, it would take another big increase in energy prices, meaningfully higher bond yields, double-digit inflation and a 1%+ interest-rate hike from the Fed (a believable but extremely dark scenario) to push stocks significantly below their June lows.

For now, it appears that we lack the negative forces necessary to re-center outcomes around the bearish case.

In my opinion, long-term investors should consider raising their core allocations to stocks into short-term selloffs that materialize in the weeks and months ahead.

Footnotes

1 Source: Standard & Poor’s, Invesco, 8/1/22.

Originally Posted September 2, 2022

How does the bottoming process for stocks start? by Invesco US

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Earnings per share (EPS) refers to a company’s total earnings divided by the number of outstanding shares.

The price-to-earnings (P/E) ratio measures a stock’s valuation by dividing its share price by its earnings per share.

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