Stepping Off the Profits Cliff

Earlier this year I broke out some Kalecki to analyze where corporate profits were headed.  The conclusion was rather simple – profits were likely to come under pressure towards the end of the year and could face substantial risk to the downside depending on the outcome of the fiscal cliff.

Albert Edwards at Societe Generale has an excellent new report out describing why we might already be in a profits recession.  In other words, forget the fiscal cliff.  The profits cliff is already here:

“We have previously highlighted that it is the change in analyst optimism (rather than the level), that seems to determine the change in the equity market (see chart below). With the change in optimism turning down, this helps to explain the weakness in the market since its July peak.

Regular readers will know that the IBES global aggregates data we use for the above charts is monthly, but my colleague Andrew Lapthorne aggregates up the weekly profits data from the stock level and publishes these in Global Market Arithmetic every Monday. His latest report this Monday had some very interesting observations.

He said “the outlook for earnings has been extremely poor in recent weeks. Yes, the US reporting season led to an improvement in near term (2012) earnings forecasts with the ratio of upgrades to total estimate changes for 2012 earnings rising from 44% to 50% over the past month, but earnings momentum for 2013 has slumped, dropping from 48% to 42%, leading to a major divergence between the two (see left-hand chart below – we contrast the US divergence with that of Europe). For earnings momentum to collapse during a reporting season is highly unusual, as optimistic forecasts are generally reeled in over the period between reporting seasons.”

He continues, “Consensus earnings growth expectations remain optimistic for next year with profits forecast to rebound globally by 12.4%. This is not particularly unusual at this stage of the year, with next year’s earnings almost always forecast to grow and with the expansion in growth often the result of Year 2 forecasts being downgraded at a slower rate to Year 1 forecasts, i.e. base rate effects. The question is not the level of earnings growth, but the rate at which earnings are being downgraded, and currently with global earnings momentum down in the low forties, it suggests we are already in a profit recession” (See Global Market Arithmetic – link).

Andy’s comment about the unusual divergence between FY1 and FY2 profits optimism cannot be fully appreciated from the chart above that appeared in the Market Arithmetic. I therefore asked our colleague Rui Antunes to show a longer time series for these data. Now we can see
just how unprecedented this divergence is (see chart below).

So it seems that while most commentators are worrying about an impending fiscal cliff, we have actually already stepped off the profits cliff. The recent decline in the equity market is more reflective of the dreadful profits backdrop than the upbeat economic data. The last time we saw this divergence between the market and the data (mid-2008), the economy had already slipped into recession some six months earlier. That is where I believe we are now. As we move into next year, expect the combination of poor profits and poor economic data to prove toxic.”

Source: Societe Generale


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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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  • Can’t trust him

    Edwards has been so spectacularly wrong so many times its hard to know when to trust his analysis. His permabear status renders him essentially useless. Like John Hussman, he has a clear agenda and therefore cannot be trusted, even when he might be making sense. He’s the Boy who cried Bear.

  • Giledain

    This Edwards fellow may have been constantly and spectacularly wrong, as you say; but unless my eyes deceive me that chart does seem to bear out Lapthorne’s observation of an equities/analyst eps ROC correlation.

  • godot10

    Is the market falling in anticipation of a solution to the fiscal cliff, not the lack of a solution?

    Does not a solution to the fiscal cliff mean (if one believes in sectoral balances) that some of the net savings of the corporate sector (which is in surplus) will inevitably pass to the government sector (which has been in net deficit). The consumer still has to deleverage further, so any improvement in the government net deficit has to come from the corporate sector….right?

    Do not the beneficiaries of the government bailout (Wall Street, the 1%, the corporate sector) now have to pay the piper regardless of the exact measures of the solution, because the government bailout never reached Main Street, and there is no water in that well.

    Does not any solution to the fiscal cliff ultimately have to trickle back, even indirectly, to reduce net corporate savings, because that is where the money is, from a sectoral balances viewpoint?

    So whatever measures are taken, do not all paths lead back to net corporate savings?

  • Mikael Olsson

    Absolutely agree that the problem of all the western world is spelled “too much idle money now sitting in corporate coffers and the financial sector”.

    But that money won’t move back to the everyday economy on its own. The only way the balance has been kept in check is through inflation + expanding credit lines, and we haven’t really had any to speak of the last few years.

    For purposes of this exercise you can stop separating govt and household and the smaller-scale productive companies – it’s all just one big circulation.

    The separation that makes sense here is “multinationals, the 1%, the financial sector” vs “everything else”.

  • Mikael Olsson

    Herp, sorry, falling back to my usual diatribe..

    The only question I ask myself here really is “why wasn’t there a recession in 96″? (Pardon if I miss something obvious, I wasn’t interested at the time, and I’m not American.)

  • Mikael Olsson

    Well, I can GUESS of course: Right around that time, money started flowing from the financial sector into IT companies (who bought stuff and paid wages = more money into the everyday circulation).

  • jquick99

    “Is the market falling in anticipation of a solution to the fiscal cliff, not the lack of a solution?” Great question, I’d like to know the answer also.

  • KB

    So, what we really need to maintain “healthy” earnings growth now, is to increase deficit to at least $1.5t? And this is not counting EU, China, and Japan spending increases.
    Not likely, I am afraid…..

  • Andrew P

    I don’t see any solution to the “fiscal cliff”. Both political parties want to go over the cliff and down the rabbit hole, albeit for different reasons. A compromise solution is impossible as long as divided government prevails, as this President is definitely NOT a deal maker.

  • Ted

    If you look closely at the first chart you notice analyst follow the market not the other way around. So the fact that analyst are bearish is more likely to be a positive for the market…