How Investors Should Brace for the Coming Earnings Recession

For much of the past year, Morgan Stanley has issued remarkably accurate warnings that corporate earnings, particularly from companies in the S&P 500 Index (SPX), will experience rapidly diminishing growth. Now Morgan Stanley is predicting an earnings recession, or profit decline, that will last throughout 2019, and possibly beyond, Business Insider reports.

"Earnings are deteriorating even faster than we expected. The earnings revision breadth over the past month has been even more negative than we expected," writes Michael Wilson, chief U.S. equity strategist at Morgan Stanley, in a note to clients quoted by CNBC. The rest of Wall Street appears to be coming around to Wilson's viewpoint, as summarized in the table below.

2019 Earnings: From Bad to Worse

• S&P 500 profits to fall YOY in 1Q 2019, for first decline since 2Q 2016
• Declines expected in 6 of the 11 S&P 500 industry sectors
• Broad-based deterioration in earnings, at an accelerating pace

Sources: FactSet, Morgan Stanley, CNBC, Business Insider

As evidence of how rapidly profit estimates are eroding, just a week earlier Wilson was advising investors to abandon U.S. stocks based on projected earnings growth rates that were still positive. At that time, he was predicting EPS growth between 1.3% and 3.5% YOY during the first three quarters of 2019, per a previous report.

The main cause of Wilson's increasing pessimism is the "earnings revision breadth" mentioned above. This is the ratio of negative to positive earnings guidance issued by corporations regarding forthcoming results. Most companies try to manage analysts' and investors' expectations downward, raising the odds that actual results will beat estimates.

Since the first quarter of 2005, the earnings revision breadth indicator has had an average reading of 2.54, based on data from FactSet Research Systems and the Refinitiv division of Thomson Reuters, as cited by BI. For the first quarter of 2019, the ratio was 3.63 as of Jan. 31, its highest reading since the first quarter of 2016. The second quarter of 2016 was the last time that S&P 500 earnings fell on a YOY basis.

Wilson also doubts that the U.S.-China trade conflict will be resolved in a satisfactory fashion. He believes that the economic relationship between the world's two largest economies has suffered permanent damage, and that U.S. companies are likely to face increased costs as a result.

Earlier in January, Morgan Stanley warned that the risks of recession in the U.S. are increasing rapidly, reaching their highest level since the financial crisis of 2008. "A rapid decline in forward earnings," sending the S&P 500 back to the lows of Dec. 2018, was predicted in this report, also from Wilson's team.

Meanwhile, both earnings growth and the U.S.-China trade war will be among the four key drivers of the stock market in 2019, per a report from Goldman Sachs. They remain relatively bullish, however, projecting full year 2019 EPS growth of 6% for the S&P 500, with 3% growth in their conservative scenario.

The most recent consensus estimates from stock analysts project that S&P 500 EPS will drop 0.8% year-over-year (YOY) in the first quarter of 2019, per FactSet as reported by CNBC.

Wilson recommends stocks that are historically undervalued versus the market, have better earnings revisions than the market, and have delivered worse returns than the market since the peak. Since Jan. 7, stocks meeting these screening criteria returned 11%, compared to 7% for the S&P 500, among them AT&T Inc. (T), CarMax Inc. (KMX), Sherwin-Williams Co. (SHW), and United Rentals Inc. (URI), per BI.