QM Equity Quarterly Newsletter

Following the first-half sell-off, the third quarter of 2022 was a tale of two periods:

• The beginning of the quarter was marked by “hope” that the Federal Reserve would engineer a soft landing and thoughts that sentiment had become too negative during the second-quarter market drawdown. This led to a strong market rally, falling U.S. Treasury yields, and leadership by high-growth, high-risk, and highly shorted stocks.
• The second half of the quarter was a complete reversal, as the Fed reiterated its commitment to reining in inflation, which led to a steep market decline, rising interest rates, and leadership by high-quality and less expensive stocks.

Looking at the time series, the market has been swinging between factors:

• Risk, growth, and short interest have been abnormally correlated, as have profitability, size, value, and momentum.
• These factor correlations contributed to the distinct “tale of two periods” shown in Figures 3 and 4.
• The underlying driver appears to be interest rates and, relatedly, the market’s pricing of a potential recession in 2022–2023.

For the quarter, growth outperformed value, and optimism won the day. We are not convinced this will continue in the fourth quarter.

• As shown in Figure 1 and the time series in Figures 3 and 4, despite the mid-quarter change in sentiment, the aggregate environment favored growth over value and risk over quality.
• We see more uncertainty in the fourth quarter and beyond: Continued Fed tightening and rising rates should continue to challenge longer-duration and more expensive growth stocks, while Fed tightening economic implications should drive negative earnings revisions in more cyclical value stocks. Our expectation of negative earnings revisions is the subject of our Market Insight section.

Market Insight—What We’re Monitoring

In our second-quarter 2022 newsletter, we highlighted that the first-quarter market decline was driven entirely by multiple contraction and that we expected negative earnings revisions to drive the next stage of the market’s decline. That view has now become close to consensus.

In this quarter’s note, we frame potential negative earnings revisions using the “outside view.” Our integrated investment approach combines the “inside view” (bottom-up knowledge of individual companies and current market conditions) with the outside view (probability of what is most likely to happen given historical precedents of similar situations). In this particular situation, the outside view is what has historically happened to earnings estimates during typical years. This needs to be paired with the inside view, which is today’s unusual macro environment featuring high inflation, supply chain dislocations, historical stimulus followed by Fed tightening, margin risk, and geopolitical tensions. One particular concern is margins, which have risen for 25 years through declining costs of goods sold; lower interest rates; muted labor costs in selling, general, and administrative expenses; and declining taxes. All four margin tailwinds are likely to be headwinds looking forward, although inflation will be an offset to nominal sales and earnings. In aggregate, we find the outside view instructive, and the inside view suggests this earnings drawdown could be somewhat worse than historical precedents.

Considering the last 15 years, we can frame likely earnings declines in the “average” year (independent of any recession forecast). Every year, as shown in Figure 5, sell-side analysts forecast year-end earnings for the 24 months leading up to year-end; for example, analysts will forecast 2023 earnings throughout the years 2022 and 2023.

We highlight three main observations:

• In most years, analysts start overly optimistic, but they lower their estimates as reality sets in (i.e., the outside view is that sell-side estimates for a given year-end should decline)
• These declines were most precipitous heading into recessions (e.g., 2008, 2020)
• The uncommon increases typically occurred as the economy emerged from recession (2009, 2021)

Using this outside view approach, we can calculate the average earnings decline over the 15 months prior to each year-end (i.e., the remaining period for 2023). For this analysis, we include both normal and recessionary periods to reflect the range of potential outcomes without making a call on recession probability, but we remove the years with positive revisions (as it’s not plausible that the economy is emerging from recession right now).

As expected, defensive sectors’ earnings held up well (health care, utilities, and consumer staples) while cyclical sectors declined the most (energy, materials, industrials, financials, and consumer discretionary). However, we realize no two periods are perfect comparisons and next year will have its own nuances. For example, it is likely that tech earnings will prove to be more cyclical than they were over the past decade, while energy may no longer be cyclical amid a decade-long bear market. The value of this model is to apply the outside view as a base rate and then apply the inside view on where those key differences may arise.

Using this framework, we can look at each sector’s valuation using both current and adjusted 2023 earnings estimates. Figure 7 illustrates how the S&P 500 and sector price-to-earnings (P/E) ratios could change—the defensive sectors’ P/E ratios stay relatively constant as earnings hold up, while the cyclical sectors become more expensive as earnings decline. Figure 8 shows relative P/E ratios compared with the market (S&P 500)—for example, while utilities currently look 19% more expensive than the market, after accounting for their earnings stability they may only be 6% more expensive.

What does this imply about current market valuations? As shown in Figure 7, the S&P 500 multiple would rise from 14.8 to 17.0 based on estimated earnings declines using solely the outside view. When incorporating our inside view reflecting macro headwinds, we believe earnings risk is to the downside. Furthermore, multiples often overshoot on the downside entering recessions until there is more visibility on the earnings floor. While we don’t forecast price levels for the market, our outside view suggests S&P 500 earnings for 2023 could fall from $241 to $210 per share.

Despite these concerns, there are always attractive opportunities in the market. Right now we are focused on reasonably priced defensive stocks (e.g., we prefer defense and health care to utilities and staples), along with cyclical stocks that we believe are already pricing in an earnings recession.