- Inflation trends show costs are moderating from their peak levels this summer.
- Earnings growth is slowing and is expected to be negative in the fourth quarter and tepid early next year.
- Layoff announcements are rising as companies try to stem decelerating earnings growth.
We’ve already seen multiple months of evidence that inflation peaked this summer. On September 8, I wrote about how gasoline prices, a major contributor to inflation, had already fallen 22% from their June high to $3.86 per gallon, a level that would be deflationary as soon as March. That timeline remains in play because gasoline prices were $3.77 nationwide last week.
However, it’s not just gasoline prices that have declined. Many commodities have retreated from their summertime highs. For example, Invesco’s DB Commodity Index ETF (DBC) , a proxy for most major commodities, peaked at $30.64 in June. It’s trading below $25 today.
The housing market, another key inflation input, is showing signs of relief, too. Rapidly increasing mortgage rates have put the kibosh on home sales, causing home prices to moderate. As a result, it’s not a stretch to assume that shelter’s year-over-year impact on inflation will decline next year, especially since record highs this year make for tough comparisons.
October’s Consumer Price Index report offered the latest conviction that inflation is falling. Headline CPI increased 7.7% year-over-year, solidly below the 9.1% increase in June.
If this trend continues, the hubbub will shift from inflation, making unemployment and earnings the most likely bugaboos next year.
Corporate earnings are falling fast, hitting jobs
The Federal Reserve’s increasing interest rates are slowing economic activity, and although moderating, inflation is still pressuring corporate operating margins. As a result, profits are falling, prompting many companies to reduce headcount.
In “Don't Expect This Rally to Last, So Put in Stops Now to Protect Your Profits,” Real Money Pro’s Bob Byrne writes:
“It won't be surprising to see folks focus on earnings estimates being too high once late December and early January roll around…Sure, we might continue higher or chop around in a horizontal channel for another few weeks. Still, by late December or early January, I expect folks to begin focusing on earnings estimates being too high.”
In Q3, FactSet reports that blended earnings growth for S&P 500 companies was an anemic 2.2%, the lowest since COVID caused earnings to plummet in Q3 2020. Importantly, more companies have warned earnings will deteriorate, not improve. Specifically, 55 S&P 500 companies issued negative guidance, versus 27 issuing positive guidance. As a result, Wall Street analysts have ratcheted back their earnings expectations.
In Q4, they expect the average S&P 500 company to see earnings per share decline by 2.1% from last year. In 2023, they’re estimating tepid growth of 1.6% and 0.9% in Q1 and Q2. It’s hard to believe that if earnings fall in Q4, those first and second-quarter earnings estimates will prove too rosy. Especially since revenue growth is also expected to drop, which will likely force employers' hands when it comes to layoffs.
Real Money’s Stephen Guilfoyle writes:
“[The] consensus view for Q2 2023 is for S&P 500 earnings growth of 0.9% on S&P 500 revenue growth of 1.3%. For the whole calendar year 2023, FactSet shows earnings growth of 5.7% on revenue of 3.4%. While the growth is paltry, the suggestion is that profitability recovers more quickly than sales. The overt implication could be taken as increased margin due to reduced expense... also known as payroll.”
S&P 500 revenue growth has exceeded 10% for seven consecutive quarters, so that outlook is discouraging. So far, companies have been able to raise prices, offsetting revenue headwinds caused by a retrenchment in consumer spending. It will be much harder to raise prices next year, so unit volume and demand will need to do the heavy lifting regarding the top line. Unemployment will climb if it doesn’t, as companies seek to kickstart earnings growth.
Last week, Action Alerts PLUS Co-Portfolio Managers Bob Lang and Chris Versace noted headcount reductions at Illumina (ILMN) , a gene sequencing company, Tencent (TCEHY) , a gaming and social media company, and Credit Suisse, a global bank. Those companies joined a litany of others who have announced plans for pink slips. They write:
“As we discussed on this week's AAP Podcast, Amazon (AMZN) also joined the growing list of companies expected to announce headcount reductions. Morgan Stanley (MS) , Intel (INTC) , Johnson & Johnson (JNJ) , Disney (DIS) , and others are expected to join a growing list of companies that includes Meta Platforms (META) , Seagate Technology (STX) , Chesapeake Energy, Philips 66 (PSX) , Opendoor (OPEN) , Twitter (TWTR) , Stripe, Microsoft (MSFT) , Citigroup (C) , and Credit Suisse that have recently announced layoffs.”
We're already seeing signs of stress in the jobs market in data. For example, an average of 289,000 jobs were created over the past three months, down from 347,000 and 431,000 over the past six months and 12 months, respectively.
Moreover, the pace of job cuts has been steadily rising. Job cuts grew 48% year-over-year in October, with total cuts exceeding any month since February 2021, according to Challenger, Gray & Christmas. Technology was particularly hard hit, with cuts increasing 162% from one year ago.
With so many companies already looking to cut payroll costs and growing risk earnings keep falling, it’s reasonable to expect unemployment and earnings will be a big focus next year.
The Smart Play
The stock market discounts six months to a year into the future. So, individual stocks tend to bottom before the stock market, and the stock market usually bottoms before the economy.
For this reason, a focus on unemployment – a lagging indicator that typically peaks after stocks have put in lows – and earnings growth, which also tends to lag the bottom in stock prices, should be kept in perspective next year.
However, a bell doesn’t ring, signaling bear market lows. Instead, the low is only known for certain in hindsight. Stocks have risen nicely since the S&P 500 put in a new low in October. That’s encouraging, but recall that many believed the June low would be the bottom, and it wasn’t.
This suggests that investors ought to expect that bear market volatility will remain a key feature for a while. There are still investors eager to sell who are trapped at higher prices, so there’s likely to be plenty of wrestling between bargain-hunters and sellers.
Sticking to the defensive playbook remains smart if you’re a short-term or swing trader. You can sell strength and buy weakness, but you’ll want to use stop losses to protect yourself against a return to new lows. Avoiding margin, which can result in forced sales, and being quick to book profits is also wise. Concentrating on less-volatile stocks, such as dividend-paying value stocks, could still be best, given fewer investors are likely trapped in those stocks that are eager to hit the sell button. It’s also smart to ensure you have enough cash on the sidelines to remain flexible. Bear markets aren’t the time to be fully invested.
If you’re a long-haul investor, take comfort in knowing this is far from the first bear market. There have been 26 bear markets since 1929, and the major stock market indexes have always gone on to new highs afterward.
For this reason, dollar-cost averaging can be a long-term investors’ superpower. By consistently buying an index fund in equal or greater installments during a bear market, investors increase the number of shares owned and decrease investors' average cost. Since this can significantly decrease the time it takes for account balances to return to new highs, consider increasing contribution rates to index funds held in tax-advantaged retirement accounts.