S&P 500 Recessionary Earnings Power

What if the global economy entered a recession in the first half of 2018? Very few analysts expect such an outcome, but that alone makes it a question worth pondering. How would US corporate profits, and by extension stock prices, fare in a typical recession?

We went back to the late 1980s and looked at corporate earnings power for the S&P 500 during past recessions. Here is what we found, using 4 quarter trailing operating earnings:

• Late 80s/early 1990s: S&P 500 earnings peaked in Q2 1989 at $25.53/share and troughed in Q4 1991 at $19.30/share. Net decline: 24.4% over 10 quarters.

• Early 2000s: peak earnings in Q3 2000 at $56.79/share, which fell to a low of $38.85/share in Q4 2001. Net decline: 31.6% over 5 quarters.

• 2008 Financial Crisis: peak earnings in Q2 2007 at $91.47/share, falling to $39.61/share in Q3 2009. Net decline: 56.7% over 9 quarters.

The math here shows that a “Typical” recession (albeit caused by large scale geopolitical events in both 1990 and 2001) creates a 25-30% decline in S&P 500 earnings. With current 4-quarter trailing S&P earnings of $119/share, that would put the next trough at $83 – $89/share.

With the index trading at 2,600, that makes the S&P 500 valued at 29-31x future “Trough” earnings. Is that cheap or expensive? A little more history frames the discussion:

• In June 1989 (the peak of that cycle for earnings), the S&P 500 was trading for 16.5x its eventual trough operating earnings (the 4 quarters ending Q4 1991).

• In September 2000 (again the peak), the S&P 500 traded for 37x the eventual earnings trough in Q4 2001.

• In June 2007 (peak pre-Crisis earnings), the S&P 500 traded for 38x the very low earnings of Q3 2009 (including the index’s only ever negative quarterly earnings).

The conclusion: even at current all-time high levels the S&P 500 is notionally cheap (29-31x) to prior “Peak” periods like 2000 (37x) and 2007 (38x), but not likely cheap enough to buffer equity prices in the case of a sudden and unexpected recession. The S&P took 7 years to get back to 1,500 after the 2000 highs, and 6 years to regain that same level after 2007. It takes much lower valuations, like the 1989 experience, to allow the index to recover in less than a year.

Bottom line: US equity markets are pricing in essentially zero probability of a 2018 recession. Options markets, as we discussed recently, are largely in the same boat. Fair enough for now - nothing in the geopolitical pot seems to be nearing a boil. And the world’s central banks remain in low-interest rate mode. But make no mistake: the S&P 500 is priced only for further earnings growth.