By Philip Moskie

What is an earnings recession? It is a generalized contraction of corporate earnings lasting at least two consecutive quarters. It usually occurs after an economic downturn that was severe enough to force consumers into reduced spending. Rising interest rates will also lead to depressed corporate earnings as a company must pay more of its bottom line on means of production. This will reduce earnings per share and will lead to an earnings recession if the challenging economic conditions persist. 

Table of Contents:

Introduction

What is an earnings recession?

How it is measured

What is the cause of an earnings recession?

Earnings vs economic recession

How do earnings recession effect the stock market?

How to adjust your investing during an earnings recession
Conclusion

Introduction:

An earnings recession is a time period when poor macro-economic factors cause a general a decline in corporate earnings. At these times, a large percentage of businesses see a drop in revenue, leading to lower profits and potentially even losses. 

Understanding earnings recessions is important because they can have significant impacts on your ability to make money in the market. By anticipating when an earnings recession is likely to occur, investors can make informed decisions and prepare for potential challenges.

What is an Earnings Recession?

An earnings recession is defined as two or more consecutive quarters of declines in corporate profits. The earnings recession usually follows a downturn in general economic conditions. 

How do you track it?

The easiest way to figure out if there is an earnings recession is to track the earnings announcements of publicly traded companies. Public companies are required to report their earnings quarterly. This makes it easy for investors to keep their finger on the earnings pulse and notice when they start to fall on a consistent basis.  You can set up a Google alert at the following URL: https://www.google.com/alerts You can have it send you alerts for all major earnings announcements 

Another way to know if an earnings recession is underway is to watch the financial news including websites and blogs. If major companies are missing their earnings and revenues the financial media will pick up on it and start reporting very quickly. Keep your eyes and ears open.

What is the cause Earnings Recession?

It is a trickle-down effect. First, the economy turning negative. Then consumers reduce their spending. Reduced consumer spending reduces revenue which in turn translate into negative earnings growth. 

Currently the federal reserve has been aggressively raising interest rates to combat a historic spike in inflation. This inflation was caused in part by the Covid pandemic of 2020. A combination of shutting down the entire economy, the printing of almost $3 trillion dollars of new money and the dropping of interest rates to almost zero caused a 40-year spike in inflation. The aggressive posture of the fed is designed to slow the economy and thus will automatically result in a negative impact on corporate earnings in general. 

Earnings vs. Economic Recession

It’s important to note that an earnings recession is different from an economic recession, which is defined as a period of declining economic activity, such as declining GDP or rising unemployment. An earnings recession can sometimes precede an economic recession, but it is not always the case.

How do Earnings Recessions Affect the Stock Market?

As mentioned, earnings recessions are part of a trickle-down effect that starts with an economic downturn. Consumers then get nervous about the economy and start to conserve. This leads to reduced revenue and earnings. If this continues an earnings recession will result.

Many market professionals believe that earnings are the only reason why stocks go up. While I may somewhat disagree with this premise, I do strongly believe that declining earnings are going to have a negative effect on stock prices. If this process continues, on a large-scale basis, it will lead to either a market correction or even worse, a bear market.

How to adjust your investing during an earnings recession

The first thing you want to adjust is which sectors you will invest in. There are some market sectors that are more immune to the macro-economic environment. The thinking is that companies in certain sectors like healthcare and consumer basics make products that will continue to be consumed no matter how bad the economic conditions get.  This means that their revenues therefore earnings will not take the same hit as those companies in other sectors.

The second thing you must adjust is the profile of the stocks you choose to invest and trade. The main thing is to consider the market capitalization and size. In an earnings recession, young growth companies tend to take big hits. Stick to larger, well capitalized stocks that will not have the same liquidity issues as these small companies.

Another adjustment you need to make is to become hyper vigilant on the earnings and revenues of the stocks you own or are considering owning. If you have decent profits going into an earnings announcement, it may make sense to get out and not be at risk when the announcement is made. The big risk here is that a company reports earnings and/or revenue “miss” and the stock goes down 10% to 15% immediately. Be smart and nimble to protect yourself.

The last adjustment you must make is to change your mindset. Market sell offs are not bad if you are properly positioned. You must think like Warren Buffet and look for truly undervalued situations. When you spot amazing companies that are trading down 40%-60% it is time to start slowly accumulating some of these oversold stocks.

Key Points to Remember: 

When you anticipate an extended period of decline in a companies profits you might consider taking the following actions:

• Switch your stock purchases to “safer” market sectors
• Switch your stock purchases to larger cap stocks
• Be hyper vigilant in tracking upcoming earnings reports especially in stocks you own
• Sleuth out amazing stocks that are way oversold and build positions in them

Conclusion:

Earnings recessions occur in times of declining corporate earnings that result from significant challenges in the economy and financial markets. They can be caused by a variety of factors, including declining demand, rising costs, and negative economic trends.

Understanding earnings recessions and the factors that contribute to them is important for investors. It’s also important to have a plan in place to prepare for and navigate an earnings recession. These strategies might include diversifying stocks and sectors you trade, going small for the time being, and adjusting the sectors those stocks are in. Investors can also consider diversifying their portfolios and looking for opportunities to buy discounted assets.

Looking ahead, it is very apparent that at the time of this writing, we will be entering a time of earnings recession caused by the fed’s fight against inflation. By staying informed and being prepared, traders and investors can be better equipped to weather economic challenges and take advantage of opportunities as they arise.