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Below is a transcript of this week’s video:

Another earnings season kicked off last week, providing investors with the final glimpses at profit trends from the tail end of 2022. The consensus average of company analyst expectations currently sits at a -3.9% year-over-year earnings decline for the S&P 500 in the fourth quarter. This is a swift drop from the estimated growth rate of about 3.7% just three months ago and a deceleration from the third quarter’s 2.5% growth pace.

Looking a little closer at the quarter, it is quite clear that the only companies delivering year-over-year growth in earnings are companies with the higher sensitivities to inflation — commodity, industrial and real estate. These companies drove their top-line revenues higher by passing along price increases to their customers.

Broadly speaking, earnings held up well for most of 2022, as the average company was also quite successful at boosting revenues by passing along price increases. This helped temporarily offset the impact of thinning margins. But these tailwinds appear to have faded in the fourth quarter.

Looking forward, the story heading into the start of 2023 appears to be one of ongoing thin margins without a top-line lift as an offset.

So, top-line and bottom-line pressures again appear to be coinciding to undermine the ability of the average company to meet earnings growth expectations. The similarities between this and past weakening economic cycles are becoming more apparent. We have shared before that earnings expectations often follow our leading economic indicator and that the average recession has historically been accompanied by a 15% decline in earnings. As a result, earnings estimates for the coming years still appear a little optimistic, and we suspect there may be downside to these estimates.

This is not to say that analysts have not been thinking this through, but they may not have yet put through the entire adjustment. The 2023 earnings per share estimate for the S&P 500 now sits just below $229, down from its peak at $252 per share earlier last year. It is important to note that this is an aggregate of analysts’ estimates for the individual underlying companies that make up the index.

An average of estimates from Wall Street strategists, whose approach is more top-down than bottom-up, currently sits at $209 a share for 2023. This is much closer to the typical earnings decline of 15% that has historically occurred during recessions.

So, let’s put this all together:

Fourth quarter earnings are showing the first true signs of weakness, albeit still only marginally. Inflation-driven sales growth helped earnings in 2022, but this appears unlikely to continue in 2023. Earnings are typically sensitive to broader economic conditions, which place pressure on companies’ top and bottom line. Consensus earnings estimates still appear optimistic heading into 2023. As earnings estimates turn over, there may be further downside to the ongoing bear market, justifying an underweight to risk assets.