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Investors want to know if markets have already anticipated profit warnings
Thursday 16 Jun 2022 Author: Russ Mould

The Federal Reserve, like so many other Western central banks, remains on the horns of a dilemma. The US central bank can either let inflation run unchecked and run the risk that damages the economy as consumers’ pockets and corporations’ margins feel the pinch, or it can raise interest rates to try and dampen inflation but run the risk that growth slows down, or a recession develops.

Stock markets are clearly perturbed. The Dow Jones Industrials is down 12% from its highs and the S&P 500 by 16%. That suggests some bad news is priced in. But other indices are clearly frightened that worse news is to come.

The Dow Jones Transportation is index is down by a fifth from its autumn 2021 zenith, leaving it flirting with a bear market, while the small-cap Russell 2000 has already been gored, as it has fallen by a quarter from its peak.

Both of those indicators are trying to rally but technical analysts will tell you the charts look ugly, while corporate news is taking on a darker tone too, certainly if a mild profit warning from Microsoft (MSFT:NDQ) and a big, bad one from retail giant Target (TGT:NYSE) are to be believed. Perhaps the US economy is weaker than markets believe?

OFF TARGET

Microsoft is blaming the strong dollar, and analysts are therefore brushing that one off, but the implication of the Target disaster is much more serious.

Target’s inventories of goods on its shelves and in its warehouses had outpaced growth in sales for four straight quarters, so something had to give – either revenue growth picked up or Target had to stop buying and start discounting.

Target has now started cutting prices and swallowing fines and penalties that result from cancelling orders on its suppliers. This combination means management expects the operating margin to slide to 2% in the second quarter, compared to 5.3% in the first and 9.8% a year ago.

That is clearly bad news for Target, but it will hardly bring cheer to the firms that manufacture and supply its products or those that ship them.

The retailer is reportedly the second largest importer of containers into the US so it is no wonder the Dow Jones Transportation index is looking so sick – data from the giant Port of Long Beach is showing flat volumes for loaded inbound containers for 2022 to date and a year-on-year decline for May.

PEAK PRACTICE

Target’s share price suggests something is amiss because it stands at levels last seen in September 2020, when the US government was handing out stimulus cheques as if they were confetti. Those cheques are now a thing of the past, interest rates are going up and inflation is eating away at consumers’ disposable incomes.

Private consumption generates about 70% of US GDP so a slowdown, either a temporary one as retailers whittle down their stocks or a longer one as consumers slow down their spending, could be a major blow to the US economy and the earnings power of corporate America.

It is here that the wider danger for US equities may lie. Based on earnings estimates collated by Standard & Poor’s, US equities trade on 20 times forward earnings for 2022 and 18 times for 2023. Both of those ratings are still above historic norms.

They also assume earnings grow to new peaks in both 2022 and 2023, which could be a false premise if Target is any guide, especially as work from Standard & Poor’s suggests aggregate consensus estimates for the US stock market are starting to fall.

In the past month, consensus forecasts for earnings per share have dribbled down by 5% for each of 2022 and 2023, to $217 and $244 respectively. The combination of above-average earnings multiples and falling earnings forecasts could quickly turn toxic, especially as the S&P 500’s operating margins are already at record highs and analysts are implicitly forecasting further improvement, despite inflation and Target’s warning.

This takes us back to Robert Rhea’s three phases of a bear market: ‘The first represents the abandonment of hope upon which stocks were purchased at inflated prices; the second reflects selling due to decreased business and earnings, and the third is caused by distress selling of sound securities, regardless of their value, by those who must find a cash market for at least a portion of their assets.’

Equity indices are trying to rally, and confound forecasts of a bear market and US recession. It is now up to investors to decide whether they are right or whether we are moving from phase one to phase two of Rhea’s downcycle.

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