Defiant stock bulls are acting like the earnings recession is a hoax

Among bear cases keeping the equity set up at night, the one that says they’re doomed because of lousy earnings is among the most seductive. But it’s also a view subject to dissent, due to the impact of Covid on recent economic history.

The situation can be seen in the seven largest stocks, all technology related, whose giant rallies since January account for almost all the market’s gains. While their earnings have endured extreme volatility in recent years as the economy busted and boomed, the group is on its way to reaching $315 billion in combined profits for 2023. That’s nearly double what they put up in 2019 before the pandemic, a long-term rate of growth that goes some way to justifying their resurgence.

Issues with timelines are also affecting perceptions of the size of their gains. While words like “bubble” and “melt-up” are often used to describe their trajectory, it’s also true that the runup has left both the Nasdaq 100 and S&P 500 with almost the same return when measured from the top of the 2022 market. Frantic gains have rolled back equally frantic losses — nothing more.

It’s a perspective that gets limited play among Wall Street strategists obsessed with Fed Chairman Jerome Powell’s campaign to rein in the economy’s bloat. But it’s as good an answer as any to those wondering how the stock market has somehow added more than $7 trillion in value over the past eight months.

As stretched as stocks have looked it’s still possible to frame them as simply looking ahead, according to Kevin Gordon, senior investment strategist at Charles Schwab.

“At major market lows, multiples tend to lead and then earnings kick in after,” he said. “There’s a lot of Armageddon analysis out there, and I just think that’s natural. Some people are just biased that way. I’m not.”

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To be sure, the Armageddon analysis has its grounding. It’s far from assured 10 Fed rate hikes won’t kick in and enact so much damage to profits that today’s valuations end up looking ludicrous. Still, as things stand, existing estimates are plausible as no more than a continuation of an earnings trend that has weathered multiple shocks already. That’s particularly true among quasi-monopoly tech companies whose vulnerability to the economic cycle is tenuous to begin with.Stocks scored their best week since March as the S&P 500 climbed 2.6% and the tech-heavy Nasdaq 100 jumped almost 4%. The strength came even as bond traders pushed out wagers on rate cuts, when Fed officials signaled further tightening after a pause in its aggressive hiking campaign. The gap between 10-year and two-year Treasury yields went further into negative territory, an level of inversion that except for in March hasn’t been seen in four decades.A common refrain in dismissing stocks’ rapid rise is to cite the signal from bonds, where rates volatility and the inverted curve show traders betting heavily on a recession. While not irrelevant, such comparisons can undersell the varying pain tolerances among the two investor classes. Because equities are buttressed both by earnings accrued over time and expectations for the future — often a distant one — stocks occasionally exhibit a somewhat less mechanical relationship to near-term economic sentiment than its inflation-obsessed sister market.

“You’ve got this tension that always exists between the bond people, who always see a threat around every corner, versus the stock people who will always see the sun coming up tomorrow,” said Kevin Caron, senior portfolio manager at Washington Crossing Advisors.
That quality largely explains the ability of the Faang group to rally as much as it did in the late 2010s and especially in 2020, a year that featured a global lockdown and the worst recession since the financial crisis. In each case, valuations that struck many as outrageous turned out to be reasonable based on earnings that materialized one or two years later. Misguided as it may be, a similar dynamic is informing the Nasdaq’s sharp upward tilt in 2023.

The index is up 38% year to date, a gain that, should it hold, would exceed all but two full years since 2009. Chalk it up to the AI craze or lower Treasury yields easing valuation pressures — but earnings optimism is also part of the calculus.

The Big Seven — including Apple Inc., Microsoft Corp., Alphabet Inc., Amazon.com Inc., Meta Platforms Inc., Nvidia Corp. and Tesla Inc. — boosted profits by 14% a year during the decade through 2022. While their combined earnings slumped more than 20% last year, the most since Meta’s debut in 2012, they’re expected to recover swiftly, rising at least 15% in the next two years. Profits will reach $362 billion in 2024, surpassing the previous peak of $336 billion in 2021.Rising confidence that’s doable is one reason that — plotted against the S&P 500 — the Nasdaq 100 has recovered virtually all its lost ground from the bruising selloff in 2022.

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To skeptics, the elevation is reason for caution, and indeed, tech stocks are far from bargains. Again, take Big Tech. With a total market cap at $11 trillion, the cohort trades at 35 times this year’s earnings.
Yet anyone mulling an exit should consider the fact that back in 2020, when the P/E ratio ended the year at 40, it proved no hurdle to share gains.

“We’re in the throes of a slowing economy and every time the economy slows growth becomes scarce. And when growth becomes scarce, stocks get more expensive,” said Michael Sansoterra, chief investment officer at Silvant Capital Management. “You have to be cognizant of valuation, but if you can only buy it when it’s cheap, you will miss this entire curve.”

For now at least, bears who had positioned for a recession are paying a price, with many being forced to chase gains as stocks run away from them, driven by better-than-expected corporate earnings and economic data.

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Granted, the post-pandemic swoon in economic activity and markets is challenging. Yet if one steps back, a case can be made that even if profits contract for the next two quarters, as expected by analysts, the long-trem trajectory of the corporate money-making machine hasn’t been greatly impaired.

Should the S&P 500’s 2023 earnings forecast come true, at $218 a share, it represents an annual growth rate of 7% in the post-pandemic era. Profits are forecast by analysts to rebound next year, rising 11% to $242, analyst estimates compiled by Bloomberg Intelligence show.

That’s a favorable setup for stocks as long as the economy stays afloat and the Fed refrains from cutting interest rates, according to Andrew Slimmon, senior portfolio manager at Morgan Stanley Investment Management.

“What’s going to happen later this year is if, let’s just say that those numbers actually come to fruition, the market is going to say, ‘oh my gosh, we’re going from a kind of a flat-to-down-earnings year to a big re-acceleration next year,” he said. “That’s how you get another leg up in the market later this year.”