As Recession Looms, Earnings Forecasts Get Slashed

Third-quarter earnings season turned out to be about as ugly as Wall Street expected going in, but the news gets worse: Rising fears of recession have analysts cutting their forward earnings estimates at an unusually rapid pace.

That's bad, because as forward estimates come down amid recession worries, the broader market's valuation becomes less attractive.

For the record, third-quarter earnings season was forecast to be especially ugly. Increased labor costs, rising input prices, supply-chain disruptions, higher interest rates and a strong dollar were projected to clobber corporate profit margins and, by extension, earnings per share (EPS).

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Back in October, analysts forecast third-quarter earnings growth of just 2.4%, according to data from FactSet. That would have marked the lowest earnings growth rate reported by companies in the S&P 500 since the COVID-19-marred third quarter of 2020. 

Cut to today, and with 99% of S&P 500 companies having reported results, the final numbers are all but in. Per FactSet, the blended earnings growth rate for the S&P 500 is 2.5%. If 2.5% turns out to be the actual growth rate for the quarter, it will mark the lowest earnings growth rate reported by the index since that infamous third quarter of 2020, when earnings tumbled 5.7%.

But it gets worse. 

"Given continuing concerns in the market about a possible recession, are analysts lowering EPS estimates more than normal for S&P 500 companies for the fourth quarter?" asks FactSet Senior Earnings Analyst John Butters in his most recent report. 

The answer is "yes," he says, and that means analysts believe recession (or at least fear of recession) is undermining current-quarter corporate profits.

Just look at what's happened in the first two months of this year's fourth quarter, Butters says. In October and November, analysts cut their S&P 500 Q4 EPS estimates by a larger margin than average. Indeed, analysts' fourth-quarter EPS estimate for the S&P 500 fell by 5.6% between Sept. 30 and Nov. 30.

To put that in context, this year's reduction in EPS estimates over the first two months of the fourth quarter was significantly larger than the Q4 average of the past five, 10, 15 and 20 years. Heck, it's the largest decline seen during the first two months of any quarter since the pandemic-scarred second quarter of 2020. 

Q2 2020 also happens to be the last time the market was staring in the face of recession. 

The bottom line is that a drop in forward estimates raises the forward price-earnings multiple (P/E) on the S&P 500. As of Dec. 2., the S&P 500 traded at 17.6 times analysts' 12-month EPS estimate, per FactSet. That's below the index's five-year average forward P/E 18.5, but higher than the 10-year average of 17.1.

Note well, however, that as of Sept. 30 – or before the slew of estimate cuts came in – the S&P 500 traded at a far more attractive forward P/E of 15.2.

Investors who find the market to be compellingly priced at current levels would do well to remember a couple of things: 1.) the S&P 500 will only look pricier at current levels if analysts keep reducing their estimates amid fears of recession; and 2.) valuation only tends to work its magic over the long haul, anyway.