With 97.5% of the S&P 500 having reported earnings, as of May 29, 2014, we can take a closer look at the results through the 1st quarter of the year. Despite the exuberance from the media over the “number of companies that beat estimates” during the most recent reported period, operating earnings FELL from $28.25 per share to $27.32 which translates into a quarterly decrease of 3.4%. While operating earnings are widely discussed by analysts and the general media; there are many problems with the way in which these earnings are derived due to one-time charges, inclusion/exclusion of material events, and outright manipulation to “beat earnings.”
Therefore, from a historical valuation perspective, reported earnings are much more relevant in determining market over/undervaluation levels. It is from this perspective that the news worsened as reported earnings dropped from $26.48 to $24.79 or 6.82% from the 4th quarter. However, despite the drop in both operating and reported earnings for the quarter, trailing twelve months earnings per share rose from $107.30 to $108.85, a 1.42% increase, on an operating basis. However, trailing twelve month reported earnings remained virtually flat rising only $0.57 from $100.20 to $100.77, an increase of 0.57%. While the headline reports were a mixed bag – digging into the details revealed a bit more troubling picture.
There is one commodity that Wall Street always has in abundance, “optimism.” When it comes to earnings expectations, estimates are always higher regardless of the trends of economic data. The problem is that the difference between expectations and reality have been quite dramatic. In a recent missive entitled the “4 Tools Of Corporate Profitability” I stated:
“There is no doubt that corporate profitability has surged from the recessionary lows. However, if I am correct in my assessment, then the recent downturn in corporate profitability may be more than just due to an economic ‘soft patch.’ The problem with cost cutting, wage suppression, labor hoarding and stock buybacks, along with a myriad of accounting gimmicks, is that there is a finite limit to their effectiveness. While Goldman Sachs expects profits to surge in the coming years ahead – history suggests something different.”
The chart below compares economic growth (forward projections are at 2% annualized) to earnings growth. Wall Street has always extrapolated earnings growth indefinitely into the future without taking into account the effects of the normal economic and business cycles. This was the same in 2000 and in 2007. Unfortunately, the economy neither forgets nor forgives.
With estimates once again in the stratosphere, and not one Wall Street analyst expecting a recession at any point the future, it is only a function of time until the next major reversion occurs. To visualize the current extremes in earnings estimates, we can view the long term cyclicality of earnings. As shown in the next chart, earnings tend to cycle regularly between 6% peak to peak and 5% trough to trough growth in earnings. With 2015 expectations exceeding the current 6% peak to peak growth rate, it is only a question of what will trip up this overly optimistic picture.
The chart below shows the consistently sliding revisions of analyst expectations versus reality with regard to corporate profitability. At the beginning of 2012, it was estimated that by Q4 of 2013 reported earnings would reach $106.16. However, 2013 ended at just $100.20 as the economy failed to recover as expected. Yet, despite a more dismal outlook in corporate earnings, stock prices have rocketed higher from the continued interventions from the Federal Reserve. Currently, as of the beginning of the year, estimates for the end of 2014 have once again began to get knocked down. At the beginning of 2013 it was estimated that 2014 would end at $119.70 versus currently at just $114.39. This is likely high as economic growth has once again failed to materialize which will continue to weigh on profitability.
As shown below, the S&P 500 has tended to somewhat “lag” peaks in earnings growth. Currently, the price of the market is running well ahead of earnings growth expected in 2015. Furthermore, the deviation in earnings from the long term growth trend are at levels never witnessed before in history. With prices well ahead of expectations, and expectations well deviated from historical norms, it is unlikely that this ends well. While there are many that suggest that “this time is different” due to accounting changes, Federal Reserve stimulus and low interest rates, history suggests this unlikely to be the case.
What has also been stunning is the surge in corporate profitability despite a lack of revenue growth. Since 2009, the reported earnings per share of corporations has increased by a total of 230%. This is the sharpest post-recession rise in reported EPS in history. However, that sharp increase in earnings did not come from revenue which is reported at the top line of the income statement. Revenue from sales of goods and services has only increased by a marginal 26% during the same period. This is shown in the chart below.
In order for profitability to surge, despite rather weak revenue growth, corporations have resorted to four primary weapons: wage reduction, productivity increases, labor suppression and stock buybacks. The problem is that each of these tools creates a mirage of corporate profitability which masks the real underlying weakness of the overall economic environment. The problem, however, is that each of the tools used to boost EPS suffer from diminishing rates of return over time.
One of the primary tools used by businesses to increase profitability has been the accelerated use of stock buybacks. The chart below shows the total number of outstanding shares as compared to the difference between operating earnings on a per/share basis before and after buybacks.
The reality is that stock buybacks create an illusion of profitability. If a company earns $0.90 per share and has one million shares outstanding – reducing those shares to 900,000 will increase earnings per share to $1.00. No additional revenue was created, no more product was sold, it is simply accounting magic. Such activities do not spur economic growth or generate real wealth for shareholders. However, it does provide the basis for with which to keep Wall Street satisfied and stock option compensated executives happy.
As I discussed at length in my recent report on “Evaluating 3 Bullish Arguments:”
“There is virtually no ‘bullish’ argument that will currently withstand real scrutiny. Yield analysis is flawed because of the artificial interest rate suppression. It is the same for equity risk premium analysis. Valuations are not cheap, and rising interest rates will slow economic growth. However, because optimistic analysis supports our underlying psychological ‘greed’, all real scrutiny to the contrary tends to be dismissed. Unfortunately, it is this ‘willful blindness’ that eventually leads to a dislocation in the markets.”
The ongoing deterioration in earnings is something worth watching closely. The recent improvement in the economic reports is likely more ephemeral due to a very sluggish start of the year that has led to a “restocking” cycle. The sustainability of that uptick in the economic data is crucially important if the economy is indeed turning a corner toward stronger economic growth. However, with the Affordable Care Act about to levy higher taxes on individuals, it is likely that a continuation of a “struggle” through economy is the most likely outcome. This puts overly optimistic earnings estimates in jeopardy of being lowered further in the coming months ahead as stock buybacks slow and corporate cost cutting becomes less effective.