The earnings shoe dropped this week following notable earnings misses by Walmart and Target. This led to a significant sell-off, as the market started to question the current estimates of robust earnings growth in 2022 (+10.2%) and 2023 (+10.1%). This also means that stock valuations aren’t as attractive as forward PE estimates suggest. The Fed continues to tighten financial conditions via monetary policy, and this should impact 2H2022 earnings, which will determine the accuracy of current forecasts.
The focus on stocks is relevant for crypto assets as bitcoin and the NASDAQ have been tightly correlated in 2022. Elsewhere, the EU proposed changes to the ETS (carbon credit) program, which got us to reduce exposure there.
Dispatch #12 on May 20th, 2022, has the following line up of stories:
- The earnings shoe dropped this week
- Bitcoin outlook from Fidelity’s Jurrien Timmer
- EU ETS program is tweaked…and we trim exposure
- Crypto is a tiny portion of household wealth
Earnings shoe dropped this week as Walmart & Target missed earnings
This was our market valuation and earnings view that we articulated one week ago in Dispatch 11.
The chart below from Fidelity provides an excellent visual of how “forward” EPS and actual EPS has evolved over time. The forward EPS underpins the forward PE of the market. Wall Street is currently predicting 9.4% earnings growth over the next 12 months.
What the chart above also shows is how earnings have declined during recessions. We see rising recession risks, yet earnings forecasts have not dipped lower. In 2022, despite low (~5%) weight, the energy sector has provided a notable boost to earnings.
Despite misses by Walmart and Target, financial research firm Factset says 1Q22 earnings are surprising to the upside. Any slowdown impact is NOT visible in the March quarter results.
Recessions have typically seen both a valuation de-rating and earnings cuts, as Fidelity’s Jurrien Timmer notes. The chart below shows 2022 performance alongside prior corrections.
Financial Conditions have tightened, but are still not contractionary
We believe economic headwinds are likely to increase as financial conditions continue to tighten. The Chicago Fed Financial Conditions Index shows it has yet to reach the neutral zero point. This is one measure that the Fed is regularly referencing now.
Source: St Louis Fed
Goldman Sachs also publishes a widely-followed financial conditions index. Their index is shown below alongside the S&P 500. What the chart below shows is that the absolute level is not even at the 2018 peak. However, the rate of change is extreme because we are undoing the historically easy policies of the Fed.
Is the earnings outlook different this time because of high nominal growth?
We’ll have to go back to the 1970s to evaluate how earnings performed during high inflation. Let’s take a look. NYU Stern provides historical earnings data for the S&P 500. The high-inflationary period from 1970 to 1983 is shown below.
What jumps out is that earnings growth slowed, but they didn’t fall except in 1975 and later in 1982/83. However, the S&P performance suffered as the 1972 level wasn’t surpassed until 1980. The prices suffered even when nominal earnings didn’t decline notably, and interest rates weren’t too high. It was only later in the 1970s that interest rates rose sharply as the chart of 10yr treasury yields shows.
This limited data set can’t provide a reliably view of the future. However, we can say that in the 1970s, even though earnings didn’t fall with high inflation, stock market performance suffered. The few remaining equity bulls point to the current inflation environment leading to high earnings. The market told us this week that they aren’t sold on that argument.
Equity performance matters to other assets too. The NASDAQ and Bitcoin futures have been highly correlated in 2022, as the chart below shows.
Bitcoin outlook update from Fidelity’s Jurrien Timmer
Regular readers know that The Dispatch is a fan of Jurrien Timmer’s analysis of long-term trends. Here’s his latest Tweet thread analyzing current bitcoin data. In a world full of bitcoin maxis and bitcoin doomers, it’s good to see a dispassionate analyst like Timmer.
Low dormancy flow corresponds with levels hit at the bottom of past cycles
Source: via Twitter
And the current value is below his long-term models using mobile phone and internet penetration.
European Union meddles with the Carbon Credit (EU ETS) program
The EU announced a proposal to sell Euro20bn worth of carbon credits (EST = Emissions Trading System) to support the energy transition. Most of the political narrative is on reducing energy dependence on Russia, which is a popular mandate. This WSJ article about the EU changes does not even mention the changes to the EU ETS mechanism. The narrative-driven pitch makes The Dispatch uneasy.
The largest risk to the European carbon credit investing was always the room for political changes to the existing program. We had previously lowered exposure after the Ukraine invasion because a few countries called for pausing the EU ETS program. With the latest news, we are reducing exposure further. The Dispatch is ill equipped to parse the tea leaves of EU politics.
Most experts in the field believe that the proposed sales (which adds more carbon credits to the market) will still leave a favorable supply-demand imbalance. We prefer to watch from a distance while the EU figures out how to balance the current energy cost spike against desire to reduce carbon. These Tweets ( one & two) from industry analyst Lawson Steel provide some color. More details are available on the official EU release.
Crypto is tiny portion of household wealth & it gains were mostly unrealized
This seems like an obvious point because crypto assets peak at a value of just north of $2tn and global stock market value peaked at over $100tn. However, the two charts below from Goldman Sachs illustrate the reality that crypto assets make up a tiny (peaked at under 0.5%) of household net worth. Furthermore, a small number of people made crypto paper gains in 2021 and many of those same people lost those gains.
$163bn of realized crypto gains in 2021 vs. paper gains of ~ $1.5tn
Chainalysis, the blockchain analytics firm, estimates that realized gains hit $163bn in 2021, up 4x from an estimated $32.5bn gain in 2020. The largest gains were in the US, according to their estimates. This realized gain is a small fraction of the estimated 2021 crypto paper gains of ~$1.5tn reported in this WSJ story. This is another example of the ebbing wealth effect.
Stay safe and do reach out if you have any questions or comments about the material in this Dispatch.
Asi
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