With the 99% of second quarter earnings reports for the S&P 500 now in, I can update my quarterly analysis of earnings and estimate trends through the 2nd quarter of 2015.
Second quarter’s results improved over Q1 as activity rebounded following the exceptionally cold winter season. For the quarter, operating earnings rose from $25.81 per share to $26.14 which translates into a quarterly increase of 1.28%. More importantly operating earnings FELL from 29.60 per share in Q3 of 2014 or 11.69% from the peak.
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, share buybacks and accounting gimmickry to “beat earnings.” (For a complete discussion read “The Earnings Season Scandal.”)
Therefore, from a historical valuation perspective, reported earnings are much more relevant in determining market over/undervaluation levels. On a reported basis, earnings improved from $21.81 to $22.80 or 4.54% from the first quarter. But as with operating earnings, reported earnings fell 17% from their Q3 peak in 2014.
The rise in both operating and reported earnings for the quarter brought trailing twelve months operating earnings per share to $108.30 which was down from $111.50, a 2.87% decrease. Trailing twelve months reported earnings fell by $4.34 from $99.25 to $94.91, a decrease of 4.37%.
Importantly, the decline in quarterly earnings is consistent with the disinflationary and weak economic underpinnings that have been exacerbated by the collapse in commodity prices, particularly oil.
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 has 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 2007. Unfortunately, the economy neither forgets nor forgives.
With estimates once again very optimistic, and given a complete disregard to the late stage of the current economic cycle, there is currently not one Wall Street analyst expecting a recession. Unfortunately, it is only a function of time until the next economic downturn takes hold, particularly given the currently weak global outlook. As shown, earnings tend to cycle regularly between 6% peak to peak and 5% trough to trough growth in earnings. In 2014, expectations exceeded the current 6% peak to peak growth rate. I said then that it was only a question of what will trip up such overly optimistic picture. We now have that answer and real earnings have fallen far short of those original estimates.
As I wrote in “Not All That It Seems,” the drivers behind the growth in earnings are not entirely organic. I have extended the chart to 2020 showing Jeff Saut’s recent extrapolated earnings growth trend. The idea of “permanent liquidity,” and the belief of sustained economic growth, despite slowing in China, Japan and the Eurozone, has emboldened analysts to push estimates of corporate profit growth of 6% annually through 2020. Such a steady rise in earnings per share would push levels to more than $183.00 per share. The problem is that such an earnings expansion has never occurred in history as it completely disregards the course of normal business and economic cycles.
The problem with forward earnings estimates is that they consistently overestimate reality by roughly 33% historically. The chart below shows the consistently sliding revisions of analyst expectations versus the reality of corporate profitability. At the end of 2014, it was estimated that by Q3 of 2015 reported earnings would reach in excess of $131.07. However, Standard & Poors then revised down their estimates to just $104.03 at the end of Q1 in 2015. As of September, those estimates are now just $93.90 as the economy has failed to recover as expected.
Estimates for the end of 2015 have once again been knocked down. While it is hoped that earnings will begin to expand once again by the end of 2015, it is quite likely that such hopes are misplaced given the current state of the global economy and potentially recessionary headwinds.
With prices well ahead of expectations, and expectations now on the decline, it is unlikely that this ends well. While there are many that suggest that “this time is different” due to accounting changes, Central Bank 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 190%. This is the sharpest post-recession rise in reported EPS in history. The issue is that the sharp increase in earnings did not come from a similar surge in revenue that is reported at the top line of the income statement. Revenue from sales of goods and services has only increased by a marginal 23% during the same period.
For profitability to surge, despite rather weak revenue growth, corporations have resorted have resorted to using debt to accelerate share 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.
However, companies are not just borrowing to complete share buybacks but also to issue out dividends. According to the most recent S&P 500 company filings, the level of cash dividends per share have now reached $10.55 which is the highest level on record. It is also the greatest deviation from the long-term trend of dividends per share since the financial crisis (highlighted in blue.)
The reality is that share 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, share buybacks and cash dividends provide the basis to keep Wall Street satisfied, and stock option compensated executives and large shareholders 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 underpinnings of current earnings growth are 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 growth. Unfortunately, with deflationary pressures rising in the Eurozone, Japan and China, the Affordable Care Act levying higher taxes on individuals, and labor slack remaining stubbornly high 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.