Dear Reader,
Greetings from Baltimore!
An insecure, aging rock star has nothing on this place.
This city has such self-confidence issues that it forces inanimate objects to brag about how great it is. That said, I do recommend the crab cake and oysters at The Prime Rib…
Today, I’m wrapping up a study with colleagues on the year ahead. We’re debating the top trends of 2023. Some have argued it will be the Fed’s pivot. Others have argued the Debt Ceiling. One guy even said that this would be the year that gold finally went to $5,000.
Bad news. They’re all wrong.
The biggest trend of the year… earnings compression.
What does this mean?
Let me break it down for you.
What is Earnings Compression?
Earnings compression refers to the decline in the earnings per share (EPS) for a company or an index like the Russell 2000 or S&P 500.
There are multiple reasons why earnings per share can decline. It can happen due to an increase in the number of shares available for stocks. It can happen when companies experience a decrease in net income (profits). It can also happen through a combination of both factors. In any case, it’s a sign of financial performance deterioration.
But there’s another factor at play in the price of a stock and how it reflects its price to earnings. It’s when investors simply decide that they’re not willing to pay as much money as previous investors for the same amount of profits.
Effectively, investors decide that valuations are too high, and as a result, a stock can experience a drop in its valuation. That was the big trend of 2022: Valuation compression.
If we see earnings decline and forecasts drop, this compression will only pull stocks much further down.
What the Charts Tell Us
Historically, the S&P 500 price-to-earnings ratio is 39% above its mean.
And the Buffett indicator – which measures the U.S. market’s valuation to GDP – is well above historical norms.
With the Fed raising interest rates and GDP expected to cool, earnings compression should rip through the markets in the next two quarters. I have a hard time understanding how consumers are not tapped out.
In 2022, valuations compressed from a PE ratio for the S&P 500 from roughly 24x to 19.7x.
Earnings compression would be the second part of a down cycle for the markets, similar to what we witnessed in 1973-74, 2001-02, and 2008-09. This period will force analysts to react to weakening economic conditions and companies’ weaker forecasts. Then, we’ll see a reset of expectations.
The earnings multiple of the S&P 500 should continue to decline.
In 2018, the Quantitative Tightening cycle helped facilitate a pullback to under 15 times earnings.
A similar escape would drive the S&P 500 to nearly 3,100. But if we see the economy move into a recession with serious bite, one must be wary of the historical earnings multiples ranging between 12x and 13x earnings.
This will be a wild ride in the year ahead. And you need to be prepared.
Earnings season will be wild, and earnings reports are the most important events for the markets after the Fed’s meetings. But what most people don’t know is that unique trading windows emerge 72 hours after a company reports. That’s the period when professional traders take advantage of volume, and capital flows around the big earnings names.
Tom Busby and Roger Scott have been trading this fascinating window for decades. And they’re tapping into this Earnings Drift anomaly.
Tomorrow, January 10 at 1pm (ET), they’ll unveil how it works. You’ll get Tom and Roger’s inside edge on how to trade earnings like a pro and target life-changing gains. Register for this free event right here.
To your wealth,
Garrett Baldwin
P.S. Let me know if you have any feedback, questions about today’s issue or anything else. Just email us at hubfeedback@wealthpress.com.
*This is for informational and educational purposes only. There is inherent risk in trading, so trade at your own risk.
Market Momentum is Green
Today, the S&P 500 continues to push higher, adding gains for our big holdings in Tactical Wealth Investor. SkyWest Holdings (SKYW), a stock I recommended last week here in WealthPress Hub, popped another 2% on the day, and energy stocks are seeing vast improvement. Right now, eight of the 11 S&P 500 sectors are in the green, and capital continues to flow into the market. I’m still being cautious ahead of the December Consumer Price Index (CPI), and I’m not shorting anything in this market right now.
