Only 2 Things Matter to Stocks Right Now

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Only 2 Things Matter to Stocks Right Now

Whether or not Federal Reserve monetary policy eventually causes an official US “recession”, every US equity investor must have a perspective on two key questions:

  • The first relates to US corporate earnings: how bad will they get in an economic slowdown, and how quickly will they recover? 
  • The second is about valuation: what will the market be willing to pay for “trough” earnings (those associated with the low point for earnings)?

The answer to the first question is relatively straightforward:

  • The S&P 500 is currently earning $228/share on an annualized basis, since Q2 earnings are coming in at $57/share.
  • A relatively shallow recession would cut that number by 10 percent, to $205/share.  That’s still better than the S&P’s pre-pandemic earnings of $162 – $163/share in 2018 – 2019, which were the prior cycle’s (2010 – 2019) peak in earnings power. 
  • History says a normal recession would reduce S&P earnings by 25 percent, taking them to $171/share.  This would still be modestly higher than the 2018 – 2019 peak run rate.

With the S&P 500 at around 4,100, that works out to a 20x multiple in the shallow recession scenario and 24x if we see a more typical recession.  Those certainly seem like rich multiples, since historical trough earnings multiples are around 15x. Common wisdom would therefore tell you that US large caps are overvalued because they incorporate literally no recession risk.

The countervailing argument is that US companies are substantially more profitable than in past cycles and therefore absolutely deserve higher valuations, even on trough earnings.  The chart below strongly points to that conclusion.  It shows total US corporate profits divided by nominal GDP since 1980. In essence, this calculation measures how much domestic economic activity ends up on the bottom line of America’s companies. 

Two points about this data:

  • US corporate profits as a percent of GDP have been increasing every decade over the last +40 years.  They started in the 5 percent range in the 1980s, grew to +7 percent in the early 2000s, then expanded further to 9-10 percent in the 2010s.  They are 10-11 percent now. 
  • In addition to outstanding management focus on generating profits, American companies have also benefited from growth in high margin tech-enabled goods and services revenues as well as non-US revenues and profits.

Simply put, US companies are remarkable profit machines and there is nothing in this analysis to suggest that this will fundamentally change any time soon.  The trend here goes back decades, making it structural rather than cyclical. A recession should not materially alter it. 

While this data may be new to you – we seldom see it mentioned outside of nerdy econometric analysis – S&P earnings data supports its conclusions.  Since 2019, when the index earned $163/share, per-share profits are up 40 percent.  Nominal GDP is only up 15 percent over the same period.

The inevitable conclusion is that yes, markets should pay a healthy multiple on whatever trough earnings the companies of the S&P 500 generate in a recession.  Not only will those likely remain robust, but the ensuing recovery should bring higher earnings power than the previous economic cycle. No one can say for sure if US equities have bottomed, but we believe investors should consider adding US large cap equity exposure here and on any weakness.