EARNINGS CONTINUE TO OUTPERFORM

We’re about halfway through earnings season and the stronger than expected earnings have gone largely overlooked as politics has dominated the investment landscape in the first few weeks of the year.  Nonetheless, the figures have been very good and we maintain our view that we are unlikely to see a sustained downturn due to the very strong underlying earnings picture and the continuing low expectations going forward.  As we mentioned before earnings season began, this was likely to be another very robust earnings season compared to expectations.  To our amazement, it is actually surprising to the upside of our lofty expectations.

Thus far, 75% of companies have outperformed bottom-line expectations with 65% of all companies also outperforming on the top-line.   Just 15% of all firms are reporting earnings below expectations.   Guidance has also been strong as analysts continue to underestimate the future growth of earnings.  Thus far, 13% of companies have increased guidance while just 2% have reduced their guidance.

A look under the hood shows a continuing problem, however.  Revenues are still not showing signs of strong organic growth.  The “backwards check mark” in earnings is still very much alive.  Year over year revenue growth is just 1% ex-financials.   Fortunately for corporations the cost cuts continue to drop down to the bottom-line.   As we previously discussed, margins are nearing record highs again:

The overall strength of corporate income statements continues to be underestimated by investors as our expectation ratio surged near its recent highs.  The indicator is showing broad strength in all facets of corporate income statements when compared to analyst expectations.  This should continue to put a floor under equity prices as we believe it will lead to future upgrades and price target increases.  Despite popular belief that this is the beginning of another major market downturn, the earnings picture tells a different story.

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Cullen Roche

Mr. Roche is the Founder of Orcam Financial Group, LLC. Orcam is a financial services firm offering research, private advisory, institutional consulting and educational services.

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  • VCC

    May it be noted that when a major market top was forming, your eyes were on the earnings picture, which is largely shaped by the fraudulent mark-to-market “profits” of banks that wish to pay out their ‘stars’ one last time before the music dies. There’s no magic indicator that can guide participants’ manic behavior. It’s about knowing when to which ratio, and having a rock solid macro picture.

    Ex-financials the earnings picture looks ugly. There’s also a reflexive relationship at play between the USD and any export-driven economies. If the dollar continues to rally, as I expect, a tail wind becomes a significant storm for any of the exports and commodities. Sans earnings and the myth of the magical printer, what else could prop this rally up, much less push it higher than 1150? Sorry man, the bear will expose genius from bul.

  • B Ferro

    out of curiosity, do multiples matter or is it only earnings that drive stocks?

    on your better than expected earnings, should we reward stocks with expanding or contracting multiples? actually, rather than asking what we think, what has the market done over the past week? it’s re-rated multiples lower on better than expected results…P/E contraction folks

    moreover, is the market a forward looking discounting mechanism? how then, can an expectation ratio, that takes into account only current beats/misses, ever portend the likelihood of future upside/downside vs. estimates?

  • http://www.LiquidBlueRealty.com John Kalinowski

    I guess I don’t understand all the excitement over companies beating the current estimates. Weren’t those estimates based on projections made when everyone thought the world was imploding? If the estimates were set way too low because everyone exaggerated the downside, is it really such a big deal when a company beats the estimate? Aren’t their revenues and profits still substantially lower on a year-to-year basis? Do we really think we’re going to see huge growth from here, when the consumer no longer has the ability to borrow against their home to finance purchases?

  • hbl

    Is there data that splits the revenue trend into domestic versus foreign? I wonder how domestic revenue has been trending.

    I would have expected recession-minded US consumers in particular to be putting downward pressure on prices… unless the S&P 500 has a large number of oligopolies?

    If domestic revenues are in a poor trend now and if the dollar strengthens for long enough to reduce foreign sales, then revenues will become a bigger drag on stock prices, right?

  • http://www.pragcap.com TPC

    I am all ears for the bear case, but investors have been calling tops for 8 months now. You’re fighting some seriously strong macro trends with the stimulus, yield curve, Fed, etc. I don’t see how the market can be forming a major top with these winds at its back.

    I am all ears for coherent bear cases though.

  • http://www.pragcap.com TPC

    The ER is not just beats/misses – it’s comprised of 12 different internal indicators – none of which is actually the beat/miss ratio. It wouldn’t be very forward looking if that were the case.

    And the PE ratio is the greatest trick ever played on investors.

  • Jon

    Hard to push the markets higher when the average P/E is over 30?

  • http://www.pragcap.com TPC

    And so we’re clear – I am still 100% hedged since I said to sell last week. I do, however, believe this turns into a buying opportunity when some of these uncertainties are clarified….A big portion of that thesis is based on the fact that earnings are solid and will ultimately trump political fears.

  • http://www.pragcap.com TPC

    The market is an expectations game. Everyone thinks the market exists in reality, but it doesn’t. There is no denying that the economy is very weak, but the economy has outperformed most investor’s expectations. Earnings are a reflection of this environment.

  • http://ourmaninnyc.blogspot.com/ Our Man in NYC

    As someone who’s bearish (net neutral currently, but with puts so risk exposure is clearly skewed), and knowing you appreciate chaos theory/fractals/etc…I’d throw out that these fingers of instability are still out there:

    – CRE: Yes, everyone knows about, but everyone knew about RRE in 2007…and that didn’t stop the banks blowing themselves up.

    – RRE: The second wave is coming (Option Arm Recasts, starting now…) and Prime defaults will be higher than historical (due to lower DTI standards introduced in 2003)

    – Sovereign Risk: Greece is the tip of the iceberg.

    – Liquidity: A simple driver for the markets in 09 — FED buys your crap MBS, you go buy Equities/Commodities/etc…What happens when the FED stops providing the liquidity (as it claims it intends to do per FOMC statements)..who’s the marginal buyer. Note the Stimulus becomes a negative contributor to GDP in Q3-10.

    – Terrorism: Always a risk.

    – China: I think it’s a bubble…inflation causes them issues (they need to stimulate but need to control inflation). Floating the yuan is the sign for me that it’s close to blowing-up (since it’s their last resort — an attempt to transfer risk from Chinese holders to foreigners). Listening to calls this E-season, China’s also the source of every mining/machinery/etc company’s positive future projections.

    – Trade/Protectionism: Go back to the Great Depression, look what happened to Global Trade (it fell, every year!). There are signs already of increased protectionism, as unemployment continues..there’ll be more.

    – Valuation: Equities have been systematically overpriced (on a PE10 basis), imho, for the last 10-15years! They’re expensive now, they will be more expensive even if S&P500 generates $70 this year and the S&P is flat. (Big claim i know, and I fully understand people not agreeing. I’ll be putting up a blog post that’ll give some data).

    – Risk Aversion/Same Trade: Anecdotal, so feel free to ignore, but from speaking with people everyone seems to have the same trade on – L Risk, S Risk Aversion. Think of all the S Treasury Trades you hear about and Long Commodities (to take the 2 flavors de jour)…that’s the same trade, just expressed differently. Imho, there are too many people who have something similar in their book and think that they are hedged.
    To take another example; the Wisconsin Board of Investments approved leveraging their investments in order to make their 8% targets. Now! When corporate bonds, junk bonds, equities, commodities, etc have all rallied! That smacks of reaching for yield, and ignoring the downside…
    Take a look at the Harvard Endowment Allocation; it’s exceptionally overweight risk assets.

    – Deleveraging: Bank’s aren’t lending, but it’s as much because there’s limited demand! Sadly, I think it’s a secular thing…the choice is take the bullet now (and declare our banks insolvent) or spread it out over 10-20years (and do a Japan).

    I’m not saying that the S&P will trade down to <650 (though I think there's a decent probability it will), more that there's substantial risk that's not priced into this market…

  • jt26

    What’s odd is that the ER works. I’ve been listening to money managers for 10+ years say that analysts are always behind the curve on the up and downside. So either the market has not been smart enough to adjust, or analysts have been making even greater errors for some reason. Could really all the money be dumb money?

  • http://www.pragcap.com TPC

    Great, great comment. My reponse:

    http://pragcap.com/is-this-a-major-market-top

  • PazzoMundo

    Happy New Year TPC,

    Thought CXO’s reference to this research paper “Aggregate Market Reaction to Earnings Announcements” was interesting in this context (http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1536894).

    Was a little surprised by the conclusion that lots of “good news” generally leads to higher discount rates (via inflation expectations?) – and hence lower prices rather than the higher…

    PM

  • FarginMarone

    >> A big portion of that thesis is based on the fact that earnings are solid and will ultimately trump political fears.

    But are earnings solid based on solid sales, or cost-cutting?

    My money’s on the latter, which is unsustainable going forward. Eventually the pullback by consumers will have to be recognized on bottom lines.

  • prescient11

    TPC, I’ll back you up here.

    Everyone, F is making a damn good profit. F people!!! In a crappy economy where no one is making major purchases, they are profitable!!

    I hear all the bear cases and agree with them. But those arguments and what the market does are two different things.

    That’s all I needed and I got long the market tonight, just a bit. TPC’s expectation ratio rising makes me feel happier about that.