Wall Street Is Delusional About Coming Stock Market Crash, Recession

The entire global economy is preparing for a growth shock. The Federal Reserve has made it clear that Americans should expect a housing correction, higher unemployment and maybe even a recession as it hikes interest rates to cool inflation.

Despite this clear warning, Wall Street is still delusional about how the stock market will perform in 2023.

Sure, the S&P 500 is down 11% over the past month and the Dow is down 9%. But estimates of how much profit S&P 500 companies will make next year are still completely out of sync with what’s to come for the economy.

In early 2022, the Federal Reserve believed that inflation was temporary – that the supply-demand dislocations caused by the COVID-19 pandemic would disappear without much use of force. Then Russia invaded Ukraine and completely upended the food and energy markets. As it turned out, inflation was harder than the world imagined. And so the Federal Reserve began raising interest rates to slow our scorching hot economy that was being swamped by demand.

Federal Reserve Chair Jerome Powell last week reiterated his commitment to bring inflation back to 2% — even if that means raising interest rates enough to trigger a recession. And, he conceded, that ultimately means pain for the job market — layoffs.

Wall Street’s rosy forecasts for corporate earnings don’t match what Powell promises for the economy. It’s about to have a reality check.

It’s a long way down

2021 was a record year for American capitalism, or at least for American corporations. US corporate profit margins rose to levels not seen since the 1950s. As supply chains faltered because of the pandemic, companies hiked prices. As inflation increased input costs, they continued to raise prices. Americans had to issue stimulus checks, and interest rates were so low that debt was easily accessible.

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Those perfect conditions are now gone. And that means earnings — a crucial part of a company’s stock valuation — will fall.

Despite the economic turmoil and deteriorating earnings outlook, Wall Street still appears relatively calm about the markets’ prospects. According to Bloomberg, Wall Street analysts expect earnings per share for S&P 500 companies to hit $229 in 2023 — a steady increase from their original estimate of $211 for 2023 earlier this year. Yes, even though the Fed is raising interest rates and threatening to trigger a recession, the market pros got it more optimistic about profits next year.

Of course, their models assume the trend lines of record-breaking gains we’ve seen will continue — maybe not as quickly, but at least up and to the right. That doesn’t make sense given the pressure the Federal Reserve is putting on the economy, even if its policies only take it from scorching heat to warm heat.

Justin Simon, a portfolio manager at hedge fund Jasper Capital, walked me through a worrying mind exercise. Imagine if it were the end of 2019 – not a terrible time for the stock market and the US economy. Even if corporate earnings fall back to those healthy levels, it’s still a long way from where the stock market is today.

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“The risk for the market right now is for earnings per share to normalize to pre-COVID levels,” Simon said, “about $160 per share.” According to Simon, if earnings were to fall back in line with earnings, it would indicate a 30% to 40% downtrend from the current market.

No one knows how much Powell will have to hike rates — or for how long — to cool inflation. Whether this leads to a brief downturn or a recession, we know that whatever comes next will not be positive for corporate earnings. Since 1960, incomes have fallen by an average of 31% during recessions. And the longer the economic slump – and with it the slump in profits – lasts, the worse it will be for stocks.

Nothing bad has happened… yet

Wall Street disputes this in part because the economy has been so resilient. Despite historical inflation, the US consumer has kept chugging along and unemployment is still at record lows. When Powell announced on Wednesday that the Fed had decided to hike rates by 0.75%, the market rose a bit, then traded sideways before falling off a cliff. Stock investors are confused, as retired Goldman Sachs partner Abby Joseph Cohen put it in an interview with Bloomberg. You don’t know how that will play out for the rest of this year, let alone next year.

Nor have companies really helped clarify this situation for their investors. In fact, they seem to be lagging behind Powell. Over at Freight Waves, my former colleague Rachel Premack pointed out that many large companies were caught off guard as Americans changed their spending habits to reflect a post-pandemic, high-inflation world. Companies like Amazon, Target and Ford have had to change their plans or lower their earnings estimates. Earlier this month, FedEx reported dismal earnings and lowered its forecast for next year due to the slowing global economy. The company’s shares fell 24% after the announcement. Those are just a few companies – the rest of America’s businesses are still figuring out what these new conditions mean for them. For example, if interest rates rise, companies that have relied on cheap debt or plenty of liquidity to survive will be in for a rude awakening.

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This is not a world where earnings continue to rise, but the Federal Reserve is changing the parameters of the economy so dramatically that Wall Street’s plug-and-chug models are useless in the face of it. Investor estimates will eventually come down when they finally wake up to the “pain” Powell promised — and when that happens, volatility will reign as the shit gets real.

All those pictures you’ve seen of a bright red stock market and sweaty traders making the sign of the cross – this is just the beginning. Wall Street has flown so high it has forgotten that stocks don’t always go up. And the higher you fly, the deeper you fall.

Linette Lopez is a senior correspondent at Insider.

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