posted on 26 March 2017
Here’s a problem.
With roughly all of the S&P 500 having reported Q4-earnings, a problem has emerged.
Despite the exuberance from the media over the “number of companies that beat estimates" during the most recent reported period, 12-month reported earnings per share are roughly at the same level as they were at the end of 2013. This has occurred during the same period the companies that report those earnings have risen in aggregate from 1848 to 2238, or an increase of 21.13%.
While operating earnings are the primary focus of analysts, the media, and hucksters, 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." This problem has been exacerbated since the end of the financial crisis, as we will discuss more in a moment, to the point to where only 13% of total revenue growth is coming from actual revenue, the rest is from accounting gimmickry, buybacks, and outright fudging.
From a historical valuation perspective, reported earnings are the ONLY METRIC relevant in determining market over/undervaluation levels. It is from this perspective the news deteriorated further as 12-month reported earnings per share in 2013 was $100.20/share versus just $94.54 at the end of 2016. Again, while asset prices have risen by 21%, reported earnings fell by -5.65% However, despite the improvement in reported earnings for 2016, the trend remains clearly negative.
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.
The chart below shows the shift of forward estimates from January, 2016 for the end of 2017. I have included estimate updates for March and August of 2016 as well as January and March of 2017. The problem is that IF you bought stocks in January 2016 based on a valuation assumption of forward estimates, you now own a much more expensive investment.
The game is simple:
Notice in the chart above in just the last month forward earnings expectations have been lowered further for this year and we aren’t even out of the first quarter yet. This downward slide of earnings expectations for this year is shown more clearly below.
Importantly, notice that estimates through 2018 are at the same level as they were in 2016.
Here is the issue. IF analysts are right this time, and they never are, and earnings do rise to $130/share in 2018, which is based on tax reform and infrastructure spending hopes, earnings will be at the same level as they were projected to be at the end of 2017 at the beginning of 2016.
Yet, at the same time, investors have continued to push asset prices higher.
Do you see the problem here?
Of course, the reality is that since forward earnings are always over-estimated by roughly 30%, and eventually revised down so companies can win the “Beat the Number" game, the market is currently even more expensive than investors realize.
Don’t believe me.
Here is the clearest way to show the forward estimate problem. Let’s take a look at where earnings estimates started in 2016 and assume we hold the analysts responsible for their calls. Here is what the progression looks like.
Estimates in 2016 were nearly 30% off the mark. Yet during that time, investors ran stocks higher (capital appreciation only) by nearly 10%.
Again, are you seeing the problem?
Earnings Manipulation Reaching Limits
There is no arguing corporate profitability improved during 2016 as oil prices recovered. The recovery in oil prices specifically helped sectors tied to the commodity such as Energy, Basic Materials, and Industrials. However, such a recovery may be fleeting as the dollar remains persistently strong which continues to weigh on exports and the recovery in commodity prices continues to remain muted as the global economy remains weak.
However, looking back it is interesting to see that much of the rise in “profitability" since the recessionary lows has come from a variety of cost-cutting measures and accounting gimmicks rather than actual increases in top line revenue. As shown in the chart below, there has been a stunning 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 221%. 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 28% during the same period.
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. Furthermore, each of the tools used to boost EPS suffer from both being finite in nature and having diminishing rates of return over time.
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.
Ultimately, 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. Eventually, you simply run out of people to fire, costs to cut and the ability to reduce labor costs. The last point is most prevalent as I discussed previously:
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 increases in interest rates by the Fed will only act as a further brake on 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.
This is not a market to overly complacent in.
Remain long, but remain hedged. The cracks in the facade are becoming more exposed.
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