What Is An Earnings Recession, And How Does It Affect Stock Prices?

Key takeaways

• An earnings recession may be imminent as consumer spending slows and high costs undercut profits on Wall Street
• As inflation and layoffs continue, talk of an earnings recession has investors worried
• Investors can protect themselves by diversifying their portfolios to include defensive stocks

The financial world has been sounding the alarm recently over a potential recession in the U.S. and the global economy. The Federal Reserve is still fighting inflation, big tech companies are continuing layoffs, and companies are gearing up to report their 4th quarter earnings. With that, fear of an earnings recession is mounting.

Morgan Stanley’s investment chief warned clients that incoming earnings reports would underwhelm investors, potentially pushing major stock indexes to two-year lows even if the economy avoids a recession. As we head into earnings season, investors are keeping watch to see if these predictions come true.

If you’ve never heard the term “earnings recession” before, don’t worry. We’ll explain what that means below—plus, how to keep afloat with Q.ai’s AI-powered Investment Kits.

What is an earnings recession?

Before answering that question, we should define a recession more generally. A recession is a significant, widespread, and prolonged downturn in economic activity. A common rule of thumb is that two consecutive quarters of negative gross domestic product (GDP) growth signal a recession. However, note that the National Bureau of Economic Research uses much more data than GDP growth when deciding whether or not to call a recession.

Every quarter, publicly traded companies must report their recent financial performance. This is an opportunity for investors to evaluate how the company has done and how the company is likely to do in the future.

An earnings recession, in simple terms, is when a majority of company profits fall year-over-year for two or more quarters in a row. For example, if 251 companies on the S&P 500 report decreasing year-over-year profits two quarters in a row, we’re in an earnings recession. The last time there was widespread talk of an earnings recession was in mid-2019. Keep in mind this was pre-Covid, and in early 2020 the economy fell into an actual recession.

The culprits

Morgan Stanley’s Chief Investment Officer, Michael Wilson, told investors in a note, “We’re not biting on this recent rally,” referring to the stock market rally between October and December last year. Wilson predicted that 4th quarter profits would disappoint investors and that an earnings recession is imminent.

But Wilson sees a glimmer of hope that once the quarterly reports reveal lower profits, the bear market will draw to a close by the second quarter. Several other analysts believe an earnings recession is inevitable this year and will set the scene for the next downturn. There are several factors causing this earnings recession, but it largely comes down to these:

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• Ongoing layoffs inside the tech sector have made consumers more conscious of spending habits. Consumer spending fell 0.2% in December, and the savings rate rose to 3.4%
• Rising rates continue to be in the spotlight as the Federal Reserve actively combats inflation. The increase in prices across the board is contributing to consumers spending less
• We saw market sell-offs in 2022 as investors were nervous about a potential recession. Ongoing fears of reduced profits may renew a selling season for stocks

The important thing now is for investors and businesses to prepare for a potential earning recession.

Preparing for an earnings recession

Before panicking, an investor should consider their investing goals. Think about whether you are a short-term or long-term investor. Not all courses of action should be the same, as each investor will have different goals and cost bases for each stock.

Short-term investors may note the possibility of an earnings recession continuing throughout the year, further dropping stock prices. These investors may want to claim profits before the trend continues. A long-term investor, conversely, may feel more flexibility since they can ride the stock for several years and give the economy time to make a comeback.

Not all downturns last a long time, and not all companies are affected equally. Remember the debatably V-shaped recovery we saw after the 2020 recession, especially for companies like Zoom or Wayfair that benefited from stay-at-home policies. As an investor, it’s generally good to compare apples to apples. A company may report lower year-over-year revenue, but if the year prior was an unusual, record-breaking year for them, it doesn’t necessarily mean their fundamentals are in decline now.

Preparation in diversification

Never keep all your eggs in one basket, and never have just one investment in a portfolio. Investing too much capital into too few companies can expose you to more risk. In 2022, portfolios heavy with tech companies took the biggest hit, while balanced portfolios suffered less damage. If an earnings recession does occur this year, it is likely to affect some market sectors more than others. Recession-proof sectors include consumer staples, healthcare, utilities, and budget businesses, to name a few.

Tools such as Q.ai make it easier to achieve a balance. Q.ai offers a wide selection of Investment Kits that balance risk and reward potential. There are Kits for long-term investing, protecting against inflation, and swinging for the fences with riskier assets. Users can select different AI-controlled features that hedge portfolios from market volatility. AI-powered Investment Kits take the guesswork out of investing.

Valuation fears

The tech sector saw massive growth in mid-2020, which continued going up through 2021. But a decline followed throughout 2022. During that period, valuations for tech companies could be misleading as the whole sector increased no matter how an individual stock performed. This made it difficult for an analyst to determine a technology company’s worth. Earnings recessions can bring the same results. Even if a company reports positive numbers for its earnings, the stock price may slide as investor confidence wavers.

The bottom line

The last two times the Morgan Stanley model predicted earnings so far below average forecasts were during the dot-com crash and the Great Recession. Respectively, the S&P 500 fell 34% and 49%. They are now warning investors that this year’s rally also looks vulnerable. Intelligent investors should watch for profit expectations and forecasts for the year. Earnings season has already begun and will continue over the next month. Investors should remember that adding defensive investments can balance a top-heavy portfolio.

Download Q.ai today for access to AI-powered investment strategies.