The term ‘”recession” is typically associated with broad-based economic downturns that can have far-reaching consequences for employment, investment, and overall economic activity.
A related concept that receives less attention but is nonetheless important for investors to understand is the “earnings recession“.
This term refers to a sustained period of declining corporate profits, and understanding it can offer insights into the health of the broader economy and financial markets.
Picture this, you’ve got a bunch of big-shot companies (think those on the S&P 500) and their earnings start to drop. We’re talking two or more consecutive quarters of these businesses’ earnings going south. That’s what we call an earnings recession.
These declines can come from a handful of party poopers – decreasing demand (customers playing hard to get), increasing costs (when your dollar just doesn’t stretch like it used to), and other wet blankets on the corporate earnings parade.
What is an Earnings Recession?
An earnings recession occurs when there’s a sustained decrease in corporate earnings or profits across a significant section of the economy.
It is often defined as two or more consecutive quarters of year-over-year decline in earnings among a substantial number of companies.
It is most commonly referred to in the context of publicly-traded companies, particularly those included in the major stock market indices, such as the S&P 500 or the Dow Jones Industrial Average.
The occurrence of an earnings recession can be due to several factors including decreasing demand, increasing costs, overproduction, geopolitical uncertainties, regulatory changes, or various other economic pressures.
The impact of these factors can lead to lower sales, tighter margins, or even losses, thereby driving the earnings downward.
While an earnings recession shares its name with an economic recession – defined as two or more consecutive quarters of negative GDP growth – the two are not always connected.
An earnings recession does not automatically lead to an economic recession, though it can serve as a warning sign of broader economic trouble on the horizon.
Conversely, an economic recession does not guarantee that all companies will see their earnings decline; indeed, certain sectors or companies might even thrive in such conditions.
Case Studies of Earnings Recessions
To understand the concept of an earnings recession better, let’s explore three historical examples:
The Dot-Com Bubble Burst (2000-2002)
The collapse of the internet-based, or ‘dot-com’, businesses at the turn of the millennium led to a significant earnings recession.
After years of speculative investment, the reality of insufficient profits came to the fore, leading to a sharp decline in corporate earnings, particularly within the technology sector.
The S&P 500, a benchmark for large U.S. corporations, saw an earnings recession that lasted several quarters, with year-on-year earnings declines of up to 50%.
The Global Financial Crisis (2008-2009)
The subprime mortgage crisis and the ensuing financial market turmoil led to a broad-based earnings recession.
During this period, corporate profits nosedived due to poor business conditions, tight credit markets, and weak consumer spending.
Major financial institutions posted substantial losses, and even sectors outside of finance, such as automotive and manufacturing, saw their earnings plunge.
The COVID-19 Pandemic (2020-2021)
The global COVID-19 pandemic caused a sharp but relatively short earnings recession.
Travel restrictions, lockdowns, and the decline in consumer spending hit many industries hard, leading to a significant drop in corporate earnings in the first half of 2020.
But like a cat with nine lives, many sectors bounced back faster than expected. Aggressive fiscal and monetary policy responses, coupled with increased demand in sectors like technology and healthcare, allowed for a quicker-than-expected earnings recovery in many sectors. It turns out, pandemics are great for online shopping and binge-watching new TV shows.
Summary
Understanding the concept of an earnings recession is essential for both macroeconomic analysis and individual investment decisions.
While an earnings recession is not always a precursor to or a consequence of a broader economic recession, its occurrence signals challenges in the corporate sector, which can have significant implications for stock market performance.