Happy New Year!
The brutal year of 2022 has finally passed and we are now entering the new year of 2023. What should we expect for the upcoming new year? If you feel you have been hit too much this year and wish a much better year is coming, I wish you good luck. Unfortunately, we are probably far from the ultimate bottom of this bear market. One strong argument to support this bearish view is the likely earnings surprises to the downside. The market won't fare well when the earnings are declings more than expected. This is probably the next shoe to drop for the market!
Stay safe and be cautious in 2023!
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To explain why, I'll briefly turn to one of history's all-time great investors: Stanley Druckenmiller.
For those who aren't familiar, Druckenmiller famously earned 30% average annual returns over his career without a single losing year. That's among the most impressive long-term track records in the history of the markets.
In a recent interview at the 2022 Sohn Investment Conference in New York, Druckenmiller was asked about his experience investing near the peak of the dot-com bubble in 1999-2000.
During his response, he pointed out that there had been a relatively rare confluence of market factors that should sound familiar to investors today. Specifically, he noted that long-term interest rates, the U.S. Dollar Index (DXY), and crude oil prices had all increased sharply over the prior year or two.
He wasn't quite sure what to make of that at the time. So, he asked an analyst friend to crunch the numbers, and what they found was startling.
In short, whenever that combination of factors had occurred in the past, corporate earnings had fallen by roughly 35% on average over the following year or two.
Now, Druckenmiller didn't specify the exact time frame of this analysis. But a quick look at price charts from that period turned up the following rough estimates:
That suggests we could see a sharp decline in corporate earnings over the next several quarters. And this, in turn, could trigger another significant drop in stocks.
For those who aren't familiar, Druckenmiller famously earned 30% average annual returns over his career without a single losing year. That's among the most impressive long-term track records in the history of the markets.
In a recent interview at the 2022 Sohn Investment Conference in New York, Druckenmiller was asked about his experience investing near the peak of the dot-com bubble in 1999-2000.
During his response, he pointed out that there had been a relatively rare confluence of market factors that should sound familiar to investors today. Specifically, he noted that long-term interest rates, the U.S. Dollar Index (DXY), and crude oil prices had all increased sharply over the prior year or two.
He wasn't quite sure what to make of that at the time. So, he asked an analyst friend to crunch the numbers, and what they found was startling.
In short, whenever that combination of factors had occurred in the past, corporate earnings had fallen by roughly 35% on average over the following year or two.
Now, Druckenmiller didn't specify the exact time frame of this analysis. But a quick look at price charts from that period turned up the following rough estimates:
- Interest rates (represented by the benchmark 10-year U.S. Treasury yield) rose as much as 65% during that period.
- The DXY rose as much as 23%.
- West Texas Intermediate (WTI) crude oil rose more than 200% at its peak.
- Interest rates are up over 200%.
- The DXY is up 23%.
- WTI crude is up over 200% (and more than 1,000% from its COVID-19 lows).
That suggests we could see a sharp decline in corporate earnings over the next several quarters. And this, in turn, could trigger another significant drop in stocks.
Given that consumer price inflation is running above 9% by official measures today, it's possible earnings may fall less than expected this time as well.
However, even a more modest decline in earnings could trigger further downside in stocks.
For example, the S&P 500 currently trades near 4,000, with a P/E of around 20. If earnings were to fall by just 15% – less than the decline in any of the 1970s recessions – while the P/E remains stable, the index would trade below 3,400 (15% lower).
However, while the S&P 500's P/E has fallen significantly from its recent extremes, it's still trading well above its long-term average of roughly 16.
If earnings fall by 15%, while the S&P 500's P/E drops to 16, the index will trade below 2,500. That would represent a decline of roughly 35% from current levels.
Yet even this estimate may be too optimistic.
Market valuations tend to be "mean reverting" – they tend to return to their long-term average over time. But the more "stretched" they become in one direction, the more likely they are to overshoot that average as they move the other way.
The S&P 500 reached a peak P/E of just over 45 in June 2021. That's the second-highest valuation we've ever seen – only slightly behind its all-time record of 47 during the dot-com boom and bust in the early 2000s.
Given this extreme, it's not unreasonable to think the market could trade well below this average valuation before making a longer-term bottom. And this is where the numbers start to get frightening.
For example, if earnings fall by 15%, while the S&P 500's P/E also drops to 10, the index will trade around 1,800.
That would be a decline of more than 50% from current levels. And if earnings were to fall more than expected, the downside would be even greater.
To be clear, I'm not predicting the S&P 500 will fall this much. But it easily could if earnings weaken significantly in the months ahead. And I believe most investors are completely unprepared for that possibility today.
However, even a more modest decline in earnings could trigger further downside in stocks.
For example, the S&P 500 currently trades near 4,000, with a P/E of around 20. If earnings were to fall by just 15% – less than the decline in any of the 1970s recessions – while the P/E remains stable, the index would trade below 3,400 (15% lower).
However, while the S&P 500's P/E has fallen significantly from its recent extremes, it's still trading well above its long-term average of roughly 16.
If earnings fall by 15%, while the S&P 500's P/E drops to 16, the index will trade below 2,500. That would represent a decline of roughly 35% from current levels.
Yet even this estimate may be too optimistic.
Market valuations tend to be "mean reverting" – they tend to return to their long-term average over time. But the more "stretched" they become in one direction, the more likely they are to overshoot that average as they move the other way.
The S&P 500 reached a peak P/E of just over 45 in June 2021. That's the second-highest valuation we've ever seen – only slightly behind its all-time record of 47 during the dot-com boom and bust in the early 2000s.
Given this extreme, it's not unreasonable to think the market could trade well below this average valuation before making a longer-term bottom. And this is where the numbers start to get frightening.
For example, if earnings fall by 15%, while the S&P 500's P/E also drops to 10, the index will trade around 1,800.
That would be a decline of more than 50% from current levels. And if earnings were to fall more than expected, the downside would be even greater.
To be clear, I'm not predicting the S&P 500 will fall this much. But it easily could if earnings weaken significantly in the months ahead. And I believe most investors are completely unprepared for that possibility today.
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