The Earnings Game

We’ve made it through another corporate earnings season. For 4Q15 earnings declined 3.3% year –over-year and revenues declined almost 4% according to FactSet data. A couple of key points that come out of the latest earnings report from FactSet, “Overall, 96% of the companies in the S&P 500 have reported earnings to date for the fourth quarter. Of these companies, 69% have reported actual EPS above the mean EPS estimate, 10% have reported actual EPS equal to the mean EPS estimate, and 21% have reported actual EPS below the mean EPS estimate. The percentage of companies reporting actual EPS above the mean EPS estimate is equal to the 1-year (69%) average, but above the 5-year (67%) average.”

“In terms of revenues, 48% of companies have reported actual sales above estimated sales and 52% have reported actual sales below estimated sales.  The percentage of companies reporting sales above estimates is below the 1-year (50%) average and the5-year average (56%).”

Of particular note, this quarter marks the fourth consecutive quarterly revenue decline for the S&P 500. The last time this happened we were in the throes of the financial crisis in 4Q08 and 3Q09. It also marks the third consecutive quarterly earnings decline, the first time we have experienced such a phenomenon since the first three quarters of 2009.

It appears we are seeing a continuation of earnings being produced on fewer revenues. We have spoken about the mean reverting nature of profit margins (see our post on January 18 entitled Hoping for the Best... but Preparing for the Worst).

The figure below shows what happened to the S&P 500 the last two times profit margins started to roll over.

The current annual revenues per share estimates for the S&P 500 call for $1155.99 in 2016 and $1227.85 in 2017 according to FactSet. Earnings per share are expected to be $121.78 and $137.69 for the S&P 500 for 2016 and 2017, respectively. For these estimates to hold true, we will need to see margins resume its upward trend climbing all the way to 11.2% by 2017. Granted that analysts’ annual estimates are notorious for starting too optimistic and working down over time. This is of some concern because as of today bottom up forecasts are not calling for earnings and revenues growth to resume until 3Q16.  

It also appears that analysts are missing the mark to a greater degree when producing their assumptions. The chart below (found in Business Insider) shows, “volatility for earnings estimates — which are based off either past or expected results — is at its widest in six years, setting up for continued volatility in the market.”

Quoted in that article, UBS equity strategist Julian Emanuel writes, “Looking back over the current cycle, the story isn’t simply about the extent to which consensus expectations have adjusted downward. Instead, the range and inherent volatility (i.e. standard deviation) of the estimates are materially higher, likely setting the stage for material surprises in the event oil and US dollar pressure subside. As with equity market volatility, investors should bear in mind that higher volatility can as easily manifest itself to the upside as to the downside…Putting it all together, we believe that earnings risk remains largely balanced with the potential for upside surprises to "be more surprising" given the historically high volatility and unidirectional (down) aspect of consensus revisions. Paired with historically defensive investor sentiment which has frequently presaged meaningful rallies, we continue to view risk to US equities as skewed to the upside.”

Mr. Emanuel clearly has a bullish bias towards the market. That is perfectly fine, but one needs to understand that this volatility in earnings can go in either direction, which means if estimates are far too bullish we could see an equally aggressive reduction in earnings. We are not predicting that will happen but are cognizant of the potential threats to the portfolio.

Looking at the rolling twelve-month eps forecasts, it appears that we are rolling over as well. Since the end of 2014, 12MF eps has been drifting lower and that hasn’t been great for equities.

This is an important point because the direction of earnings forecasts have a fairly tight correlation with the direction of equities so the one month slope of the earnings forecast line is useful to watch. Bear in mind forecasted earnings are a reactionary lagging indicator so by the time you actually pick up a negative reading in the slope of earnings, the market has already given up a lion’s share of its gains and you’ll be a day late and a dollar short.

Tracking the rate of change in this figure has some use though. The slope of the line has a natural tendency to be positive (as does the stock market) so by tracking the rate of change, we could get a warning even if the slope of the trend is positive but decelerating. This may lead to a bit of noise and false readings but we look at it as a “head’s up” for potential problems. The chart below shows a z-score for the one month slope of twelve month forward forecasts going back twenty years.

When the z-score falls below zero, it indicates decelerating or negative slope and should be used as a warning signal. If the figure recovers quickly then we breathe a sigh of relief and move on with our investment and trading thesis. But once that line continues lower to around -1 standard deviation, bad things happen in the market. The ultimate story here is that we definitely need earnings and revenues to improve dramatically in 2016 to justify a continued bull market. 

Financial Engineering

It seems clear that corporate America has been exploiting financial engineering in order to inflate the bottom line. This can go on for several quarters or even years before reality finally sets in. Given the dwindling results and the excessive levels of earnings tomfoolery one may anticipate the day of reckoning is closer than expected.

Lance Roberts from Real Clear Investment Advice has been highlighting this very situation for some time now. His commentary is brilliant and we personally believe that his analysis is ahead of the curve. On corporate earnings he states, “The failure to understand the “quality” of earnings, rather than the “quantity,” has always led to disappointing outcomes at some point in the future.

According to analysts at Bank of America Merrill Lynch, the percentage of companies reporting adjusted earnings has increased sharply over the past 18 months or so. Today, almost 90% of companies now report earnings on an adjusted basis.”

“Back in the 80’s and early 90’s companies used to report GAAP earnings in their quarterly releases. If an investor dug through the report they would find “adjusted” and “proforma” earnings buried in the back. Today, it is GAAP earnings which are buried in the back hoping investors will miss the ugly truth.

These “adjusted or Pro-forma earnings” exclude items that a company deems “special, one-time or extraordinary.” The problem is that these “special, one-time” items appear “every” quarter leaving investors with a muddier picture of what companies are really making…Why is this important? Because, while manipulating earnings may work in the short-term, eventually, cost cutting, wage suppression, earnings manipulations, share-buybacks, etc. reach their effective limit. When that limit is reached, companies can no longer hide the weakness in their actual operating revenues. That point has likely been reached.”

Bottom Line: The Corporate earnings picture appears to be deteriorating. That is not a good sign for equities and worth watching closely. We are not predicting a bear market at this point but are cognizant of the pitfalls ahead that could damage the portfolio. In light of the earnings picture, ineffective global monetary policy, slowing global economic growth and a technically broken U.S. equity environment, we continue to believe the lows have not been set and our directional bias remains lower.

Happy Trading.

 

Joseph S. Kalinowski, CFA

Email: joe@squaredconcept.com

Twitter: @jskalinowski

Facebook: https://www.facebook.com/JoeKalinowskiCFA/

Blog: http://squaredconcept.blogspot.com/

 

Additional Reading

The Big Earnings Con – The Felder Report

 

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