Corporate Profits Set to Decline...Has the Recession Arrived?

Three months ago I mentioned the possibility of a forthcoming profit recession hinted at by Richard Bernstein and James Montier. Profit margins appeared to be peaking at historically high levels and despite their strong mean-reverting tendency, earnings projections assumed profit margins would remain near peak levels. With an increasing number of companies reporting negative earnings growth (year/year) and the probability of declining government deficits, the downside risks to those forecasts seemed pronounced.

According to Bloomberg,

Analysts predict members of the Standard & Poor’s 500 Index in the U.S. will report a 1.1 percent average drop in second- quarter earnings, after estimating a gain as recently as last month

A significantly stronger dollar combined with weakening growth in Europe and China may have brought about a US profit recession even earlier than growth pessimists expected. While the federal deficit may be large enough to maintain mediocre economic growth in the US, it appears inadequate to support a continuing rise in corporate earnings. For the time being, analysts are expecting earnings growth to rebound substantially in the second half of the year and return to double-digit growth in 2013 and 2014.

The important question for investors is whether this quarter of declining earnings will be the first of several consecutive, similar to the past 2 recessions, or if current expectations for a return to growth will prove true, similar to 1998. My bet is on the former, although I expect current forecasts will prove too high in either case. If earnings are beginning a sustained period of decline than current multiples may also need to be revised lowed. The likelihood of this combination taking hold seems largely overlooked by the present market. The current earnings season will shed light on how significant the deterioration in earnings has been and looks to be going forward. I have a feeling the market will not be happy with the results.

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