Is This the Most Anticipated Recession in History?

We are just finishing the 2nd earnings season of 2023 and once again, corporate earnings are coming in better than expected. Of all the worries coming into 2023, a meaningful decline in corporate earnings was near the top of the list for the majority of market participants, including ourselves. The price of a stock has two components: the multiple (PE Ratio) and the earnings per share (EPS). The formula for a stock’s price is below.

EPS x Multiple = Stock Price

For example: If a company earns $1 per share and has a multiple of 20 then the stock’s price is $20.

Question: What determines a stock’s multiple?

Answer: The stock market is a forward-looking instrument. Meaning, it prices stocks based on their future earnings potential, not necessarily what the company is currently earning. For that reason, investors are willing to pay a multiple of the current earnings in anticipation of earnings going up in the future. The more earnings are projected to grow in the future, the higher the multiple of current earnings investors are generally willing to pay.

A company’s earnings are so important because they have a direct correlation to the overall stock price. The good news is corporate earnings have not disappointed in the first two earnings sessions of the year. The question is, will that continue, or will the slowing economy begin to influence earnings later in the year. Of course, we do not know the answer, but the numbers are looking more positive than anticipated so far this year.

Will There be a Recession?

Again, no one knows the answer to this question. However, the vast majority of market participants seem to think we will have a recession at some point this year or maybe early next year. In my history I cannot recall a time when the market has been so overwhelmingly convinced that a recession will happen. Before my time, when information was not transmitted instantly across the globe like it is today, it is hard to imagine the market being so one-sided on a recession outlook as well.

So that begs the question: Is this the most anticipated recession in history? If so, what happens if we do get a recession? What happens if we don’t?

We Get a Recession

If the market is indeed a forward-looking instrument, and if the overwhelming majority of market participants believe we will have a recession, then shouldn’t the current market prices and valuations already reflect the impending recession? The answer, in our opinion, is probably yes. We think that a recession is likely, and we also think that the market has priced in a lot of the downside risk of the recession due to the fact that a mild and short recession is so widely expected. For that reason, if a recession is confirmed, we think that the market will react negatively at first, but we expect the downside negativity to be short lived and that would likely be the bottom that the market can finally move higher from. Historically, in bear markets where there is a recession, the market tends to bottom shortly after a recession is declared.

We Do Not Get a Recession

When the market is heavily weighted to one side, and a different thing happens, you get fireworks. If the market is widely expecting a recession and no recession comes, in our opinion, the market moves sharply higher. This scenario was thought to be quite unlikely until recently. It is still probably not the most likely scenario, but the odds are better after seeing a couple quarters of corporate earnings remaining resilient.

Big Picture

Our most likely scenario at this point is that we get a mild recession that is short. If this is the case, we think the market finds a base to move higher from shortly after the recession is announced. We believe that companies with historically strong and consistent earnings growth as well as high profit margins will be the types of stocks that will fare the best in this type of environment. Mega-cap tech is a good example of profitable companies with sticky revenue streams. Apple, Google, Microsoft, Nvidia, Salesforce, etc. These companies are so entrenched in our society today that they seem to be almost recession proof. Are companies going to stop using Microsoft Outlook because of a recession? No. In addition to mega-cap tech, all our models require companies to have consistent earnings and revenue growth as well as high profit margins to be included in our portfolios. Not to say that stocks like this will not have rough patches like over the last 18 months, but generally the market loves highly profitable companies with consistent earnings growth.

Looking beyond the short term, we believe that 2024 and beyond look quite good for stocks. We continue to monitor inflation and earnings declines as potential negative catalysts. We are also monitoring some new potential negative catalysts such as the stability of the banking sector and the effect work-from-home will have on the commercial real estate market. In our view, the banking sector issues we have seen recently are likely limited to smaller banks that took on a lot of long-term interest rate risk like Silicon Valley Bank. The larger banking institutions are likely going to be fine and will be supported by the government if things get bad. This is not 2008. However, the commercial real estate market may be different. Are companies going to renew their leases when they run out if their staff is working from home either part-time or full-time? Our office is located on the 29th floor of one of the nicest buildings in downtown Minneapolis and we can see the effect of this issue firsthand. Next door to us is a large foundation with beautiful offices that are completely empty most of the time. Will they renew their lease in a couple years? Probably not. Companies sign long term leases for their office buildings. Usually 7-15 years. We likely won’t begin to see major effects on the commercial real estate market for a couple more years, but then it has the potential to be a major issue with property values and financial institutions who lend money to real estate developers. We generally avoid much exposure to real estate and financials in our models, but the systemic potential of the problems are worth keeping an eye on.

We are coming up on 18 months since the market peaked back in November of 2021. Time is a major factor in bear markets. After long bull markets like we saw over the past decade, the market needs time to settle in and find a base before starting another move higher. We should be getting close to the point where enough time has passed for there to be a reasonable expectation that we can put the events of pandemic inflation and rising interest rates in the rearview.

This commentary in this article reflects the personal opinions, viewpoints and analyses of the Element Squared Private Wealth employees providing such comments and should not be regarded as a description of advisory services provided by Element Squared Private Wealth or performance returns of any Element Squared Private Wealth client. The views reflected in the commentary are subject to change at any time without notice. Nothing on this website constitutes investment advice, performance data or any recommendation that any particular security, portfolio of securities, transaction or investment strategy is suitable for any specific person. Any mention of a particular security and related performance data is not a recommendation to buy or sell that security. Element Squared Private Wealth manages its clients’ accounts using a variety of investment techniques and strategies, which are not necessarily discussed in the commentary. Investments in securities involve the risk of loss. Past performance is no guarantee of future results.