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John Engle
John Engle
Articles (406) 

Earnings Recessions: Imperfect but Important Indicators

Contracting corporate earnings do not always signal economic trouble, but they are still worth watching closely

October 08, 2019 | About:

Corporate earnings, especially those of publicly traded companies, are often seen as a reflection of the strength of the underlying economy. This makes some sense, given that these companies are by far the largest employers and touch nearly every corner of the economy. When public companies are doing well, it stands to reason that the economy is as well. Likewise, when the reverse occurs and earnings contract, it can often be an indicator of trouble in the broader economy.

However, it is clear upon a deeper examination that earnings recessions can be a fallible indicator of more widespread problems.

An imperfect indicator

The relationship between corporate earnings and economic climate is not always perfect. As we discussed in an Oct. 7 research note, it appears that a so-called earnings recession has taken hold among companies in the S&P 500 index, yet the economy has continued to hum along fairly well, and the stock market has remained near all-time highs.

Clearly, there are limitations to the power of earnings weakness as an indicator of market and economic strength. However, taken together with a number of other indicators, it adds an important piece to the overall picture. Indeed, some analysts now fear that another weak earnings season could be all that is needed to trigger broader economic turmoil.

A challenge of aggregation

One problem for earnings recessions as an economic indicator is that they suffer from data aggregation discrepancies. A data analyst's decisions on whether or not to exclude things like one-off charges and fines from earnings can have a considerable impact on the aggregate earnings figure, especially when they affect large firms such as Apple Inc. (NASDAQ:AAPL) or Facebook Inc. (NASDAQ:FB), 

In a late August interview with MarketWatch, Invesco’s Kristina Hooper explained the limitations of current earnings recession calculations:

“There’s definitely differences among different research providers. It’s not usually this significant, but we’ve had periods where it was as large...Earnings recessions are a lagging indicator. When we discuss an earnings recession, we’re looking in the rearview mirror. What’s far more important is where we expect earnings to go, and that’s an even more inexact process...A lot of this has to do with where the tariff wars take us. There’s no playbook for tariffs.”

Factoring in new variables, such as tariffs, has only made aggregate earnings calculations and projections more volatile.

A passing phase, sometimes

Adding to the issues concerning earnings recessions is their historical weakness as a direct indicator of broader economic health. In essence, earnings recessions do not necessarily indicate an economic recession is on the horizon. As Charles Schwab’s Randy Frederick explained in August, economies cannot be judged by short-term earnings blips alone:

“Just because we might have a slight decline in earnings growth doesn’t mean that we’ll have a full blown recession.”

Yet, for all its inherent weaknesses, Wall Street analysts have not diverted their focus from the earnings recession indicator. In fact, some worry that, while an earnings recession on its own might not normally be enough to cause widespread economic woes, it might be in these times of heightened market uncertainty and economic fragility.

A need to dive deeper

The subject of earnings recessions as indicators of broad economic problems deserves a more thorough discussion. This is especially true in these rarefied times, in which, despite fears of escalating trade war and slowing domestic economic growth, stocks continue to test all-time highs. The market could have far to fall if investors lose faith. 

Disclosure: No positions.

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About the author:

John Engle
John Engle is president of Almington Capital - Merchant Bankers. John specializes in value and special situation strategies. He holds a bachelor's degree in economics from Trinity College Dublin and an MBA from the University of Oxford.

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