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Are We Headed for a ‘Profits Recession?’

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In just two weeks the second-quarter earnings season will officially begin when Alcoa reports after the market close on July 8. Analysts at Factset are predicting a 4.7% decline in earnings, which would be the biggest drop since Q3 2009.  S&P is forecasting a 4.1% decline for the second quarter, a far cry from the more than 4% growth it was forecasting at the beginning of the year.

S&P has also substantially cut its earnings expectations for the third and fourth from its initial forecasts at the beginning of the year.

“Earnings forecasts have been coming down quite precipitously, which then begs the question: Are we headed for a profits recession?” asks Sam Stovall, U.S. equity strategist at S&P Capital IQ, which held a webinar on the topic earlier this week.

He defines a profits recession as when a rolling 12 months worth of earnings are flat or lower compared with those of the year before. There have been 13 such profits recessions since World World II, and 10 of them were either accompanied or followed by an economic recession, says Stovall.

At this point Stovall expects operating earnings will grow 0.4% for the year, not quite a profits recession but mighty close to one, and he gives just 10%-15% odds of an economic recession. U.S. GDP fell in the first quarter 0.2%, but that was an upward revision from 0.7%.

Stovall says there are two key factors missing from the current economic landscape and from forecasts that argue against an economic recession even if there is a recession in profits: the U.S. Treasury yield curve and housing data.

Seven out of 10 recession since 1952 were preceded or accompanied by an inverted yield curve, which occurs when short-term interest rates are higher than long-term rates. In the other three recessions, the spread between short- and long-term rates was less than positive 1%. “We don’t see an inverted yield curve around the corner,” says Stovall. The current yield curve is a positive 2.4% since short-term rates are near zero and the 10-year Treasury yield is near 2.4%.

Stovall also notes that since 1960, seven of the last eight recessions were preceded by a 30% year-over-year decline in housing starts. Housing starts in May fell 11.1% from April to a seasonally adjusted annual rate of 1,036 million but were 5.1% higher than the level in May of last year.

“We could come close to a profits recession but that will probably not translate into an economics recession,” says Stovall.

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