Are Earnings Estimates Too High?

In last week’s Market Commentary, we suggested that the risks of a recession have increased. A confluence of gathering headwinds have led the Fed (and others) to reduce their projections for GDP growth this year, and further cuts may be necessary later in the year. Fed economists now expect US GDP to increase by 2.8% in 2022 prior to the effects of inflation. The new projection is down from 4.0% at the Fed’s meeting in December. While that may not sound like a big reduction, that 1.2% decrease translates to about $275 billion in economic activity in a $23 trillion economy. For perspective, $275 billion is equivalent to about $833 for every man, woman and child in the US. It should also be mentioned that the Fed dramatically increased its projection for inflation in 2022 to 4.3% from the previous projection of 2.6%. It should not come as a surprise to anyone as we’ve all been paying much more for gas, groceries, housing and many other goods and services. In response to the increasing inflationary pressures, the Fed signaled that it could increase interest rates at all seven of its meetings this year, further inhibiting economic growth.

Given the downgrade in economic growth expectations, it may be somewhat perplexing that earnings expectations for 2022 and 2023 continue to rise. The chart below shows that consensus earnings estimate for the S&P 500 have risen in nearly uninterrupted fashion for the past couple of years. It is true that, to date, companies have been reporting fairly robust demand even as they raise prices to recover the rising cost of labor, commodities, transportation and other expenses. Another way to say this is that companies have “pricing power.” But could businesses be at risk of losing that pricing power going forward?  Consider the following uncertainties:

• Will demand remain robust as COVID-related stimulus initiatives expire and savings, especially on the lower end of the income spectrum, become depleted? 
• What if inflation continues to grow at a faster rate than incomes, squeezing those consumers most inclined to spend their incomes? 
• How will large international US companies offset the 10% appreciation of the dollar over the past nine months (an estimated 40% of S&P 500 earnings come from outside the US) or the significant slowdown in economic growth outside the US (particularly China)? 
• What if there are government-mandated closures resulting from another COVID outbreak? 
• Will rising interest rates take a bite out of earnings as companies refinance their debt at higher rates? 
• Will corporations continue to repurchase as much stock if the cost of borrowing is significantly higher?  
• How will a protracted war affect the prices for key agricultural, energy and metals commodities?
• And perhaps most importantly, where will businesses find the labor necessary to meet demand if demand remains robust?

Current earnings estimates don’t seem to adequately account for the growing list of risk factors. The next two charts show that after eliminating the effects of inflation, earnings are expected to grow at a much faster pace than GDP over the next three years. In fact, if we use the Fed’s estimates for PCE inflation to adjust for inflation, S&P 500 earnings are expected to grow at over 3x the rate of GDP in 2023 and over 4x the rate of GDP in the year 2024. These earnings estimates appear aggressive given that: 1) S&P 500 profit margins are already at multi-decade highs, and 2) the aforementioned cost pressures are likely to cut into those high margins. 

But there is a valid counterargument that stock market bulls are espousing. Provided that we can successfully identify companies that are able to retain pricing power in this environment of high inflation, investors could actually gain some protection against inflation by owning stocks. 

Consider the case of hypothetical widget competitors WidgetCo and WidgetMax, each of which sold 10,000 widgets for $1.00 each last year (2021). The companies had identical cost structures in 2021, which means their margins were the same. However, WidgetCo has developed a new feature for the widgets it expects to sell in 2022. As a result of this new feature, the company expects to increase the number of widgets it sells by 2% while also passing on the full extent of inflation in 2022, which is expected to be 6%. You can see in the table on the left below that the 2% growth in widget volume, coupled with 6% price increases and stable margins, produce 8% operating profit growth this year – higher than the expected rate of inflation of 6%. 

But WidgetCo’s success comes at competitor WidgetMax’s expense. The widgets manufactured by WidgetMax do not have the new feature. Therefore, WidgetMax loses some of its competitiveness and pricing power. We assume WidgetMax is only able to sell 9,800 widgets this year, representing a decline of 2%. To make matters worse, WidgetMax finds that it is only able to raise prices by 2%, which is well below the 6% expected rate of inflation. We also (charitably) assume that WidgetMax is able to maintain its 50% gross margins, but that its operating expenses grow at the rate of inflation, or 6%. Under this scenario, WidgetMax’s operating profit would decline by 4% even though it was able to push through small price increases.

As I noted mentioned last week, there are valid reasons to expect demand for goods and services to remain robust even in the face of high inflation. Consumers, in the aggregate, still have a lot of savings available. Real estate and stock prices remain near all-time highs after 3 very good years. There is pent-up demand as the effects of COVID recede (notwithstanding the new variant). Supply chains are unlikely to remain in disarray forever. And most importantly, anyone who wants a job can get one, and wages are rising. And one last consideration: If demand starts to dip a bit as a result of rising inflation and interest rates, it would not be unreasonable to expect the Fed to reverse course and walk back its plans to raise interest rates (although this scenario would likely require some improvement in supply chains and therefore less inflationary pressures.)

But this is the time when your homework counts. A strategy of “buying the market” through index ETF’s has been a winning formula during this market pullback, but that may not continue as investors separate the wheat from the chaff. Only the most competitive companies are likely to retain their pricing power and gain market share during this period of high inflation. We remain very comfortable owning a diversified portfolio of high-quality stocks and bonds within portfolios that are designed to endure when markets are weak and thrive when markets are strong. Please let us know how we can help you, or someone you know, reach your long-term financial goals.