The U.S. economy has managed to weather plenty of beatings over the past year, and the long bull market has continued to chug along in spite of mounting fears about an escalating trade conflict with China. As signs mount of an economic slowdown, some analysts are beginning to fret. Others, however, remain confident that the bull market can continue despite the slowdown.
As companies begin to report third-quarter earnings over the next month, we may find out which view is right sooner rather than later.
The specter of an earnings recession continues to loom
Weakening corporate earnings have been causing considerable consternation among analysts and investors. In June, whispers began to spread of a looming earnings recession that could threaten the survival of the bull market, and might even serve as the harbinger of a full-blown recession.
What is an earnings recession? Similar to an ordinary recession, which is defined as two consecutive quarters of economic contraction, an earnings recession occurs when corporate earnings contract for two straight quarters.
This summer, as the economy appeared to be teetering, many analysts began to fret that an earnings recession was imminent. Indeed, by late June, the analyst consensus indicated an expectation of an earnings recession lasting through the third quarter, according to data compiled by FactSet. Those fears have hardly dissipated in the months since.
The market can survive an earnings recession
Earnings recessions can hardly be considered positive occurrences as they often indicate a broad economic weakness. However, earnings recessions do not necessarily indicate that an economic recession is imminent. As Brad MacMillan, chief investment officer of Commonwealth Financial Network, noted in an article published on July 19, earnings recessions have already occurred twice during the current economic expansion, yet the stock market has held its ground:
“Even if we do end up getting an earnings recession—and remember, that will not be this quarter and probably not next—it doesn’t mean the end of the world. In fact, if we go back 10 years, we can see that we did have an earnings recession in 2012 and 2014–2015. Earnings, both reported and operating, were down the requisite two consecutive quarters in 2012 and six quarters in a row in 2014–2015. That wasn’t a great time for the economy or the markets, but the expansion continued and markets are higher now than they were back then. Even when we do get an earnings recession, it will be something normal that happens on a regular basis.”
An earnings recession can occur without an economy falling apart. When other indicators begin to show signs of weakness, however, there may be reason to worry.
Verdict
It may be too early to tell whether we are indeed facing an extended earnings recession, but it is increasingly clear that things are not moving in a particularly upbeat direction. More and more indicators are flashing red and that should give any serious investor pause.
Investors would be wise to pay close attention during this earnings season.
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