The end of earnings growth?
If you look at the earnings growth, in 2010, the first year of the recovery, it had a sharp rise of above 100%. But since then it has been a downward trend. Corporate profits may soon be contracting
It’s earnings season. Like the calendar seasons there may be a change in the air. Since the middle of 2009, corporate earnings have consistently grown, but that might be about to stop. Before earnings are reported, it is traditional for companies to give gloomy forecasts to talk down the estimates, and then exceed them. This usually gives a pop to the stock when the company ‘beats’.
Not this time. With half the US S&P companies reporting, the percentage of companies reporting, EPS above estimates is in-line with recent historical averages, but the percentage of companies reporting revenues above estimates is below recent historical averages. The problem is that the ‘beats’ did not get the reaction that the companies would have wanted. The average stock has declined by 0.35% on the first day following the report of its earnings. It has been a particularly disastrous earning season for Tech stocks.
The average Tech stock has fallen by 1.6% on the day following its report. In the past year a ‘beat’ would usually mean a large rise in the stock on the following trading day. This season it results in a gain of 0.45%. While a beat does not lead to a celebration, a miss can be dire. If a Tech stock misses, its average decline is 6.71%. Twitter dropped 14%. Others have fallen 20% or more.
Are these numbers trying to tell us something? Perhaps. Certainly corporate profits have risen dramatically. If you look at a chart of earnings growth, in 2010, the first year of the recovery, it had a sharp rise of above 100%. But since then it has been a downward trend. Corporate profits may soon be contracting.
This should hardly be surprising. Corporate profits usually revert to mean. Presently they are close to an all time high as a proportion of gross domestic product (GDP). Exactly what the mean is, has been a matter of debate. The fact that they revert is not. The question between the bulls and the bears is, whether corporate profits are just a bit higher than historical averages and nothing to worry about or a bubble that is about to burst.
The bears will point out that the 2008 fall, followed by the recovery of 2010, was one of the largest spikes in history. The acceleration of profits has been much sharper compared to other business cycles. This appears to be surprising, given that economic growth has been tepid at best.
The explanation is not hard to find. Easy money policies provided by the US central bank have allowed companies to profit from extremely low borrowing. Low labor costs and a favorable tax codes have also helped grow profits even though demand has been weak.
For example Apple, the world’s most valuable private company, has boosted its earnings by buying back shares and keeping its profits off shore and away from American tax collectors. Although Apple has a huge $150 billion cash pile, $130 billion of that is outside of the US. To boost its shares and profits, Apple wants to buy back from $60 billion to $90 billion of its own shares. It doesn’t have the money in the US, so it has to borrow it. It has already floated a $17 billion bond 12 months ago and wants to do another $17 billion.
What is wrong with this scenario is that Apple is not using the money to invest in things that will actually make more money. It has simply utilised the conjunction of a generous tax policy and free money to engineer a rise in its stock which no doubt helps management. In the short run it has helped shareholders, but there may be problems down the line. Buying expensive stock with massive debt is not a lasting strategy for growth. Tax codes can change. Cheap money can disappear.
Like financial engineering, using cost cutting to boost corporate profits also has limits. Companies have tried to get as much out of their employees as possible without hiring additional workers. As a result, productivity has increased. Eventually, growth will demand more hiring as this week’s US job report may have indicated. But more workers will eat into corporate profits.
The result is that estimates for profit growth have been revised down substantially from the beginning of the year. Earnings estimates for the S&P 500 companies were revised down 4.4%. Of course this is quite common. In 20 of the past 25 years, analysts have revised down earnings growth by an average of 8% over the year.
It is not just the US market that is having second thoughts. European earnings estimates have also been wildly optimistic. Like the last three years, 2014 started out with 8% to 15% earnings growth forecast. In the past, these expectations have fallen over the year to -6% to 1% growth. Forecasts for European growth have moved from 13% at the start of the year to just 8% now and falling. Of the 374 Stoxx600 European companies that have reported their first quarter results so far this year, 101 have disappointed consensus earnings expectations.
Forecasts for global growth have also been cut. They started the year at 11%, but have since been cut to 2%. No doubt they will continue to fall as the year progresses.
The result of strong earning growths has been exceptionally strong stock markets that are trading at or near all time records in several countries. They grew by 13% in 2012 and managed a remarkable 24% last year. Market valuations always look to the future and over the past three years the future for corporate profits has seemed rather bright. With a change in expectations, no doubt there will also be a change in valuations. So corporate profits will not be the only thing to fall.
(William Gamble is president of Emerging Market Strategies. An international lawyer and economist, he developed his theories beginning with his first-hand experience and business dealings in the Russia starting in 1993. Mr Gamble holds two graduate law degrees. He was educated at Institute D'Etudes Politique, Trinity College, University of Miami School of Law, and University of Virginia Darden Graduate School of Business Administration. He was a member of the bar in three states, over four different federal courts and speaks four languages.)
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