I have published a daily piece since 1998, but I’m really a big picture guy when all is said and done. The investment community has turned into a bunch of trading junkies over the years, so I am compelled to get into the weeds. But the fundamentals ultimately win out over everything else, and defining what is short term and what is long term is purely subjective.

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David Rosenberg: Time to call it the way I see it — the earnings recession is underway Back to video

In 1999, I was labelled Mr. Horse & Buggy because I somehow just didn’t understand the “New Economy.” I was having eggs thrown at me in 2007, but once 2008 rolled around, all anyone wanted to do was make me an omelette. And here I stand alone — perhaps not entirely alone since Morgan Stanley’s chief strategist Mike Wilson and I are joined at the hip — in suggesting that the rally off the October lows was yet another one of these castles built on sand.

Look, if your financial adviser called you up with a stock recommendation and said, “The fundamentals are lousy, but look at that price momentum,” would you hang up the phone? Or maybe call your local regulator? Would you really buy that stock? Please say no. But this is the current state of affairs in the equity market.

Do the math

Until just the past couple of weeks, it hadn’t dawned on the S&P 500 that the real 10-year interest rate had jumped all the way back to 1.5 per cent — up almost 50 basis points since the start of February. When we match this level of real yields in the past to what the forward P/E multiple that coincided with it, it shows 15x. Not 18x.

You know what that means, don’t you? It means that even if we luck into the “no landing” scenario, interest rates alone dictate that the intrinsic value of the S&P 500 is 3,300, not 4,000. If we get a “hard landing” and apply that fair-value multiple to recessionary earnings, then we are talking about sub-2,700. That sounds excessive, I know, but that’s the math.

There is this view that the United States economy is going just dandy, and yet real private final sales slowed to less than a stall speed of a one-per-cent annual rate in the final three quarters of 2022 and were flat as a Crêpes Suzette in the fourth quarter. Nothing ever moves in a straight line, so we get a countertrend bounce in January and everyone from the media to Wall Street economists to the Fed go completely off the rails.

Not to mention the skew from one of the top five per cent balmiest Januarys of all time and the distortions to nonfarm payrolls and the service-sector imputations in the consumer price index that just about everyone buys into hook, line and sinker. The weather, until this week, was so warm that natural gas prices have plummeted 66 per cent since mid-December, oh, but that hasn’t exerted any impact on the “hot” seasonally-adjusted economic data so far this year? Sure thing.

The market for critical analysis is apparently not close to being as lucrative as the market for barking back the headline data to the general investing public. All anyone needs to see is how CEOs in this reporting season are talking repeatedly about four things they see in their own businesses: order books contracting, inventories rising unintentionally relative to sales, consumer savings being depleted and head counts being too high in comparison to production schedules.

Private-sector demand has already flatlined and we haven’t come close to seeing the full brunt of what the U.S. Federal Reserve has already done because the peak effect is always in year two after the tightening cycle begins (and lingers into year-three … of course, this doesn’t apply to 1965-66, 1983-84, 1994-95, or 2018-2019, but the Fed didn’t keep tightening into an inverted yield curve in those “soft landing” episodes).

The ‘R’ Word

The problem here is that everyone is focused on lagging or contemporaneous indicators, but who can blame them when the Fed is doing the exact same thing? Then again, if you missed it, the Fed did utter the “recession” word four times in the latest set of minutes, the most since June 2020 and that even tops the most frequent mentions of the R-word at any meeting in the 2008 Great Recession. They can’t come out and say it openly, but it is abundantly clear that recession is the way the Fed feels is necessary to crush this inflation cycle for good.

That may end up being laudable for the future. After all, look at the “short-term pain for long-term gain” strategy unveiled by Paul Volcker in the early 1980s that ended up ushering in nearly a decade of uninterrupted economic growth and a huge bull market (then again, Ronald Reagan was president, not Joe Biden, and Congress was filled with Democrats who were economic conservatives as opposed to today’s band of left-leaning interventionists).

The problem at this point — and this is amazing — is that a recession will come as a big surprise to a wave of financial markets pricing in a soft (slow growth, no recession) or no landing (growth accelerating — fantasy, but this theme has been gaining traction). Time to call it the way I see it. Equity investors pay for earnings, not gross domestic product. And the earnings recession is underway with S&P 500 EPS down 2.3 per cent year over year so far in this reporting season.

Pundits cheering earnings that beat estimates should either be taken to jail or at least the woodshed for their reckless behavior. Fifty lashes at least for extreme disingenuousness.

At the beginning of the year, the consensus forecast for fourth-quarter earnings was US$56.12. It is now US$54.38, for a three-per-cent haircut. What is more important, however, is the full-year 2023 EPS, and on this score the consensus call has gone to US$220.92 from $222.42 at the start of January. Even better, at the market price lows last October, the 2023 prediction was around US$237, and they have therefore come down seven per cent since that time.

Long cash

The Fed is raising rates into the most inverted yield curve since the spring of 1981 and into a contraction in earnings and downtrend in earnings estimates, and the clowns I see being interviewed in print and on bubblevision are espousing theories that a new bull market has commenced. If it all weren’t so sad, it would be funny. I’m not laughing. But I should be since I am happy being long cash, and at five per cent, that is a bargain for what you are earning in the major averages, straight up and on a risk-adjusted basis.

I have a long fuse when it comes to being patient on the bullish call on Treasuries, which I realize has flown in my face these past few weeks. But I had Wall Street veteran Bob Farrell as my mentor, so I know about two things: discipline and resolve.

Notwithstanding the rally on Feb. 23, as the bulls are putting on a brave fight defending the 50-day trendline, the major averages have been losing you money these past few weeks. It’s obviously been no picnic in bonds, but from here the 10-year T-note must approach the highs at more than 4.3 per cent to generate a net loss in total return terms. The stock market (minus four per cent) has already done that in the past two weeks. The difference is that a 3.9-per-cent yield on the 10-year Treasury is providing a far better antidote to price erosion than is the case for a 1.7-per-cent dividend yield in the S&P 500. Just saying …

David Rosenberg is founder of independent research firm Rosenberg Research & Associates Inc. You can sign up for a free, one-month trial on Rosenberg’s website.

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