For the first half of this year, I steadfastly refused to join Club Recessionista. I don’t believe we’re already in a recession and I’m optimistic that a moderate Fed can effect that soft landing by gradually raising rates to throttle inflation.

no more.

As I mentioned to Tom Keen last week, Nick Timiraos in the Wall Street Journal revealed the Fed’s intention to raise rates 75 basis points, putting a check on my hopes for a slowdown in non-recessionary growth.

A soft landing is now officially RIP.

What I have instead are questions about what the rest of 2022 will look like and how much of a loss it holds through 2023. Here are those five questions:

1. Will the second quarter earnings (released this month) disappoint or has the market already tempered expectations?

2. How much will the economy slow in Q3 and Q4?

3. How badly will third quarter earnings hurt?

4. Will the economic recession continue till 2023?

5. How much is the price in the stock market now?

Let’s dive into each of these:

1. Will the second quarter earnings (released this month) disappoint or has the market already tempered expectations? Q2 earnings disappointed, but at least so far seem modestly in line with expectations. Companies were disappointed but not heavily penalized for this.

Contrast this with the reaction to Q1 earnings (April) when various companies were brutally punished for barely missing consensus expectations. General rule: Companies that disappoint but don’t sell have bad news at their prices.

This is more consistent with a mid-cycle slowdown than the full on-end of a bull market

2. How much will the economy slow in Q3 and Q4? The trillion dollar question. We have already seen a massive slowdown in home sales. There are other troubling changes in consumer behavior: Two Wall Street Journal columns report that a massive shift toward cheaper store brands and less expensive names is already putting pressure on consumer food, beer and tobacco companies.

We don’t have much insight into the automobile market due to lack of availability; It is a reasonable assumption that higher financing costs will reduce consumer spending there as well. Other durable goods like appliances, furniture and even HELOC-financed additions/renovations can expect two moderates in the coming quarters.

3. How badly will third quarter earnings hurt? This may be the hardest question for everyone to solve as we are only three and a half weeks into the 13-week trimester. Pandemic lockdown drives cost of driving up demand for 2 years; Americans are going on vacation, traveling, watching movies at the theater, visiting family, etc. This is offset by higher prices and the worst consumer sentiment we’ve seen in decades.

Despite inflation and weak sentiment, consumers – at least for now – are continuing to do what they love to do: spend like there’s no tomorrow.

But there is a tomorrow and my expectation is that if the Fed tightens excessively (as they appear to do) then the next 12 months will be less economically strong than the previous 12.

4. Will the economic recession continue till 2023? Too many variables to address this question with any degree of confidence. However, when we look at economists’ consensus expectations for Federal Reserve cuts in 2023, that tells us that this group is not just a recession but a deep and long-lasting enough FOMC to respond aggressively.

5. How much is the price in the stock market now? There are so many variables to the answer to this question that reverse engineering potential Q3 and Q4 earnings and coming up with some multiple seems like a fool’s errand.

I would recommend the following: A 20% decline in the S&P 500 is a fairly reasonable way to discount a mild downturn. If we had a deep recession or a more severe earnings decline (from record highs) we would have to drop from -28% to 32%.

It’s hard to extrapolate much worse than a slight economic contraction from where we are today. The economy, corporate revenues, earnings, and consumer spending are path dependent to some degree. Households are in good shape and corporate balance sheets are very healthy This is why I have such a hard time imagining anything much worse than a moderate (mild to worse) recession.

So, my expectation is that we’re now about 2/3 of the way through the sell-off, and I can foresee that downgrades will be revised and overcome with weak Q3 earnings or even a weak September warning season.

Of course, all these are wargaming only possible scenarios. We don’t invest based on predictions, and any number of random surprises can make the economy perform appreciably better or worse.

We go through these exercises so as not to be surprised about some of the possible outcomes if they succeed.

see more:
Weak earnings reports aren’t fazing investors after brutal year for stocks (WSJ, July 24, 2022)

in the past:
Risk and Reward: Two Sides of the Same Coin (July 20, 2022)

Rally🤗, Multiple Compression✔️, Earnings¯\_(ツ)_/¯ Recession😔, Double Bottom⁉️ (July 18, 2022)

Too late to sell, too early to buy… (Jun 16, 2022)

The Capitulation Playbook (May 19, 2022)

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