WHAT TO EXPECT THIS EARNINGS SEASON
In early January I said the back half of the year was likely to be characterized by earnings estimates that are too high. And for the first time in over a year analysts are cutting their estimates right on cue:
“For the first time in more than a year analysts are cutting their forecasts for Standard & Poor’s 500 Index earnings, jeopardizing gains from the biggest September rally since World War II.
Estimates for S&P 500 companies’ combined 2011 profit fell as low as $95.17 last month from an August high of $96.16 and posted the first quarterly reduction since the three months ended June 2009, according to more than 8,500 analyst forecasts tracked by Bloomberg. The revision came as the benchmark gauge for U.S. equities rose 8.8 percent last month, the largest September advance since 1939.”
David Rosenberg of Gluskin Sheff says these estimates are still far too high:
“Indeed, this is the bottom-up S&P 500 operating EPS estimate that is currently driving equity valuations — if you don’t believe it, then go to page 26 of Barron’s (Facing Up to the Real Third Quarter). That would be a 14% gain on top of this year’s anticipated 36% bounce. But here’s the problem, the economy is no longer accelerating, it is decelerating. And to show how a sub-2% real GDP growth can wreak havoc with corporate earnings when margins are close to peaks rather than troughs, the national accounts data show vividly that on a sequential seasonally-adjusted basis, pre-tax corporate earnings (without IVA and CCA) barely rose at all in Q2 (+0.9% QoQ). So continued double-digit YoY growth (the consensus is +24% for Q3) is masking the slowdown evident on a quarter-by-quarter basis.
Here’s the rub: to get that $95 operating EPS for 2011, we either need to see at least 7% nominal GDP growth, which last happened in 1989 when inflation was 5%, not close to zero, or margins manage to reach new all-time highs. We won’t entirely rule this out, but will give it 1-in-25 odds of occurring. All we can say is that the base case is for low single-digit nominal growth and some margin compression so frankly we could be looking at something closer to a $75 earnings stream next year. Moreover, when one slaps on a 10x multiple on that — consistent with the economic uncertainty commensurate with a post-bubble deleveraging cycle — then getting to 750 at some point in the S&P 500 is not at all out of the question.”
Rosenberg is likely correct barring some miraculous economic rebound in 2011. Unfortunately, the many macro headwinds are likely to persist well into 2011. That means the meager recovery in revenues is likely to continue. Thus far, revenues have remained the crux of the economic problem. When sales fell companies were forced to fire workers. Without a strong rebound in revenues there has been no need for hiring. With very low aggregate demand due primarily to the weak consumer, revenues just haven’t rebounded despite a nice rebound in bottom line growth. Currently, revenues per share (S&P 500) are just 6.5% off their trough and 15.5% from their all-time highs:
Companies have been cutting costs at a blinding rate as they protect their profits. The primary input here has been unit labor costs which have declined to their 2006 levels:
The result of this cost cutting has been a remarkable rebound in profit margins. Currently, profit margins are just 1% off their 2006 highs, This has been the story behind the rebound in profits thus far. It has been anything but organic:
This likely means there is more room to cut costs, but we’re reaching a point of stagnation in profit growth. Cost cutting is not a sustainable story and as revenues fail to pick up the slack we’re seeing a vicious cycle develop. The lack of a revenue recovery results in continued cost cutting which results in continued low levels of employment which results in continued low levels of revenues which results in continued low levels of aggregate demand (so on and so forth). Unfortunately, the geniuses at the Fed and Treasury have failed to recognize this recession for what it was – a balance sheet recession and so they have not provided the needed aid to households that might spark a recovery in the consumer. Instead, they focused most of their energy on the banks and the results now speak for themselves.
The upcoming earning season is likely to be reflective of the recent past and this continuing weak trend in revenue growth and continued cost cutting. Q3 should be somewhat similar to Q2 earnings – a generally high level of beats (65% by my estimates) with relatively tepid guidance as the macro economic environment remains difficult and visibility remains poor. My expectation ratio is calling for another solid set of quarterly figures, however, the strong earnings cycle deteriorated in recent quarters and is now trending down. This reflects the very high levels of optimism at the analyst level and the more muted expectations by corporations.
In summary, the market has likely priced in fairly good earnings after the September rally. There has been a distinct trend in recent earnings seasons in which equities have rallied into the earnings season, remained robust through the first few weeks and then sold off as it becomes evident that earnings are clearly priced in and the catalyst subsides. Another strong earnings season is likely on deck, but don’t be surprised if it doesn’t provide much of a boost to a market that has already priced in continued economic recovery.
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.
Follow Me:
19 Comments
I agree with Rosie on the “E”, but not so much on the “P/E”. We are not likely to get a 10 P/E on forward mid cycle earnings unless there is a trough (recession) first. So if Rosie wants to say double dip recession and SPX 750 I’ll agree, but that will be on earnings of more like $50 due to recession.
I agree though probably for a bit different reasons – I just don’t think PE ratios are useful. There are too many moving parts and too much guesswork involved. 750 comes if we see a very nasty double dip. At this rate you just never know. The government looks entirely inept. If we got some sort of exogenous threat (China, Europe, etc) who knows how low we could go. For now, it looks like muddle through continues and you have to trade the market….I certainly don’t think this is the beginning of a new bull market like many people do, but I am also not calling for a 35% collapse like Rosie is….
Why is the PE not useful?
There are only 2 moving parts – price and earnings.
If you standardize the data across history you’ve got a useful benchmark for where you are in a cycle.
Moreover, if you use trailing earnings you’ve eliminated the guess work.
Price/Sales or EV/Sales instead?
You still only have 2 inputs and like the P/E, the second involves guess work too.
Either way, the SPX P/S is something like 1.25 right now vs. secular bottoms of ~0.5x, correct? That equtes to60% downside.
The same holds true for Price/Book multiples, roughly speaking.
The Shiller P/E is 21x vs. secular bottoms of ~7x – 67% downside.
All three square nicely.
And if you believe the P/S mean reversion and not the P/E, why would your outlook (unless you’re talking nearer-term) not include the possibility of something greater than a ~20% decline (assuming that is what you’re thinking as 35% is too high)?
I’d use almost any metric over p/e. The E can be heavily distorted by items like D&A, one-time charges, earnings from acquired companies, asset sales, stock based compensation etc. CFOs have become a lot more creative in the past 20 years with the result that bottom line earnings are often not a reliable gauge of a company’s true cash generating capabilities.
P/BV and P/S are much more difficult to manipulate.
Not when averaged over 10 years and when aggregated at the full market level and when including “non-recurring” items.
Was book value not a specious metric when attempting to value the market and bank stocks at the cycle peak in 2007 to the extent that the equity for ~20% of the SPX’s market cap at that time consisted of paper assets (consumer credit/liabilities) that would never be repaid and would instead, end up bringing the economy to its knees?
How do you standardize the data over history? FASB and GAAP rules have changed so many times that I don’t know how you can come up with a reliable gauge for standardized earnings. The treatment of stock based compensation is one example that stands out, and I’m sure there are more.
On the other hand, sales are sales. Very hard to play around with that.
I’ll concede your point on book value. They played around with that definition in the mid 00′s that it lost its reliability.
I just remembered a perfect example. I know, I know, anecdotes are not data, but this is a real beauty.
I worked with a company recently that had done a private placement. The placement included warrants of course. Well, the accounting rules stated that the warrants had to be treated as a liability which fluctuated with market changes. If the stock went up in the quarter, the company recorded a LOSS on the warrants. If the stock went down, they recorded a GAIN. WTF??? That’s the kind of nonsense that goes on below the operating line that makes bottom line earnings so unreliable.
I concede your point on GAAP by and large but would note that despite the historical vagaries in accounting aggregate EPS over time are only marginally impacted by those items vs GDP / inflation trends.
We would both agree that P/S is best.
A company I covered when on the sell side placed warrants in it’s capital structure, ZQK, and I agree, the accounting was redic, both for the G/l and the share count calc.
TPC,
I’ll go with Rosie on this one. You and our economy have been extremely lucky for the last 18 months. As I have said, we are like a juggler with about 40 plates in the air. If one bad event occurs, then the whole system collapses. Take your choice of defulting nations from the PIIGS to those in eastern Europe. Add in the potential crises headed toward us in housing and CRE. Unemployment paychecks are starting to run out, and the Obama government is attacking businesses right and left ( where are the jobs going to come from?). The Obama Healthcare Plan is forcing insurance costs to skyrocket, and this is hurting people and businesses. This list goes on and on as you know, which is why I believe we have been fortunate to go this far without hitting the next leg down. Unfortunately as Olivier Blanchard has said, we have used up our fiscal bullets and do not really have anything viable from that sector to help us in this next phase. And there has never been any doubt in my mind ( as well as Rosie’s and many others) that this next phase is coming and is unavoidable.
Rosenberg is wrong and has been wrong on the earnings front. You shouldn’t look at the earnings only from US side, a lot of companies derive half or more earnings from overseas. Unless the China falters, I don’t see how micro factor can pull the stock market down. On the macro level, you need a liquidity shock to force people out of stocks, we will never have a liquidity crunch as long as central banks are printing money.
I say all eyes should be on China, if China’s inflation is out of control, then game is at the end.
You sound like another sucker who has fallen for the BS about the Fed being able to generate real recovery with low rates. Have you ever heard of Japan?
Sucker, have I ever said they can generate real recovery? Can you read?
You need to correct your first statement. Rosie proved to be correct at the end of last year on his earnings predictions after taking heat all year from the media when it appeared that he was going to be wrong on the low side ( he predicted $55-$60 when the consensus all year was over $70, we ended at $59). Now just wait for the end of 2010 and I’ll bet he will be correct again.
Don’t forget that a 10% drop in $ means a 10% pop in earnings for multinationals (DOW) overseas earnings in $. Convenient just before election.
Thanks for another great post.
Regarding aggregate demand, I haven’t seen anyone anywhere do an analysis on the effect of strategic defaults on aggregate demand. It seems to me the banks’ slow processing of defaults have been an unintentional and hidden stimulus to the economy. According to Lender Processing Services, Inc., as of July 2010, the average length of time a loan in foreclosure had been delinquent was nearly 470 days. An LA Times article quoted a study that found:
Whatever the actual number of defaults, the money that homeowner squatters are not paying in mortgages while they still live in their homes are helping to keep aggregate demand up and partially explains why the economy hasn’t yet fallen as much as the leading indicators suggested they would. The current halt to foreclosures because of bad paperwork will extend this process. We are getting the positive effects of this “stimulus” now, but will have to recognize the costs when the tidal wave of foreclosures rolls in.
TPC,
you stated “There has been a distinct trend in recent earnings seasons in which equities have rallied into the earnings season, remained robust through the first few weeks and then sold off as it becomes evident that earnings are clearly priced in and the catalyst subsides.”
Looking at the earnings seasons in Jan/April/Jul it was on average a full month run before the sell-off. Sounds like a call to get longer to me.
Could very well be. I am in a “risk off” mode as I see the risk to the downside here, but that doesn’t mean we couldn’t move 5% higher as earnings beat. The estimates have been slashed mightily in recent months so don’t be shocked when the banks and everyone else surprise to the upside. Just look at Alcoa’s joke of a report. They report a 4 cent beat on estimates that we cut in half in the last 2 months. The stock will likely surge when it reopens.
Isn’t that funny? The market goes nuts over AA’s report which is like dunking a basketball on a 5 foot hoop. Everyone ooohs and aahhhs.
Yeah, could stay quite strong into the first few weeks of earnings season. The trend has been to sell after apple reports….