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Wednesday, November 23, 2022
Today’s newsletter is from Sam Rothe author of TKer.co. Follow him on Twitter at @SamRo. Read this and other market news wherever you are with Yahoo Finance app.
Revenues – aka the “top line” – don’t have to deteriorate much for profits to really suffer.
“[A]At the end of the day, it’s usually margins that do the heavy lifting during an earnings recession, not top line growth, due to the power of negative operating leverage,” wrote Mike Wilson, chief US equity strategist at Morgan Stanley. Monday.
Operating leverage is the extent to which the change in revenue translates into operating profit. For example, a company with 5% sales growth and 15% profit growth has higher operating leverage than a company with 5% sales growth and 10% profit growth. And it works both ways: a company with high operating leverage will see its profits drop faster as its sales decline.
Companies with a lot of fixed costs relative to variable costs tend to have high operating leverage.
Wilson offered a little more color on his current view of operating leverage in a November 7 research note (emphasis added):
…our economists don’t officially forecast a recession for next year, but they assume we’re barely getting around one. As we noted, from a profit perspective, it may be worse because it means companies aren’t downsizing as they typically do when revenue growth slows. This will put even greater pressure on margins as the rate of change in real growth and inflation – ie nominal GDP – falls sharply. In other words, the decline in the rate of change in revenue growth exceeds the ability of companies to adapt quickly enough to avoid negative operating leverage. this is what drives our EPS forecast well below consensus for next year. Labor shortages created by lockdowns and de-globalization reduce companies’ willingness to let employees go for fear of never getting them back. This is a new dynamic that American investors did not have to consider in the last 30 years, when labor was much more fungible and cheap.
Work is a huge cost for companies. And so, when demand cools, it would make sense for companies to lay off employees to cut costs, as the amount of work to be done decreases.
However, the past two years have been marked by persistent labor shortages as businesses struggled to hire amid a rapid economic recovery. Because they lacked the capacity to meet demand, companies missed sales opportunities.
This dynamic has led some economists to speculate that companies would have an incentive to engage in “labour hoarding” or retain workers despite slowing demand. The idea is to ensure that you have enough staff for when demand eventually recovers.
The downside is that labor costs don’t come down as sales deteriorate, putting undue pressure on short-term profits.
This is the negative operating leverage that Wilson talks about.
And that’s why he expects S&P 500 earnings per share (EPS) to fall to $195 in 2023 from around $219 this year. According to FactSet, the consensus estimate on Wall Street is for earnings to be $232.
The good news is that Wilson sees this deterioration in profitability as a short-term problem.
“While we view 2023 as a very difficult year for earnings growth, 2024 is expected to be the opposite – a growth rebound year where positive operating leverage resumes – i.e. the next boom” , he wrote.
With this boom, he estimates that EPS will rise to $241 in 2024.
Editor’s note: There will be no Morning Brief published on Thursday November 24th. We will resume our normal publishing schedule on Friday, November 25.
What to watch today
7:00 a.m. ET: MBA Mortgage Applicationsweek ended November 18 (2.7% over the previous week)
8:30 a.m. ET: Durable Goods OrdersOctober preliminary (0.4% expected, 0.4% in previous month)
8:30 a.m. ET: Durable goods excluding transportOctober Preliminary (0.0% expected, -0.5% in prior month)
8:30 a.m. ET: Initial jobless claimsweek ended November 19 (225,000 expected, 222,000 the previous week)
8:30 a.m. ET: Continuing claimsweek ended November 12 (1.520 million in previous week)
9:45 a.m. ET: US S&P Global Manufacturing PMINovember Preliminary (50.0 expected, 50.4 in previous month)
9:45 a.m. ET: S&P Global US Services PMINovember Preliminary (48.0 expected, 47.8 in previous month)
10:00 a.m. ET: University of Michigan Consumer SentimentNovember final (55.0 expected, 54.7 before)
10:00 a.m. ET: Sales of new homesOctober (570,000 expected, 603,000 in previous month)
10:00 a.m. ET: Sales of new homesmonth-over-month, October (-5.5% expected, -10.9% in prior month)
2:00 p.m. ET: minutes of the FOMC meeting, November 1-2
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