Markets don’t seem to have factored in the bad news
HOW bad has this corporate earnings season been? Let me count the ways. According to Thomson Reuters, whose survey of earnings estimates is widely used within the market, profits for S&P 500 companies fell 3.5 per cent in the fourth quarter of last year, compared with the final quarter of 2014. This was not just about the 74.5 per cent collapse in energy companies' profits - which was driven by falling oil prices - utilities, industrials and materials companies also saw declines.
But it is worse than that. The real damage has been in forecasts for the current quarter, expected to show a 5.7 per cent annual fall, when on New Year's Day brokers were braced for a rise of 2.3 per cent. "Earnings management" by companies, as they steer brokers to a forecast they can beat, is common; a writedown on this scale is not. But it is worse than that. It is global. According to the quant team at Societe Generale, earnings estimates for the whole of this year for the constituents of the MSCI World index, the main benchmark for developed markets, are now 12 per cent lower than they were last summer, after the biggest monthly cuts to consensus predictions since the disaster year of 2009.
Brokers can of course be wrong. They often are. And they tend to be institutionally over-optimistic, as this helps to sell stocks. But the direction of their forecasts tends to be accurate. Earnings momentum matters. And such a sudden and sharp resetting of their forecasts shows that companies themselves, with a better grasp of their prospects than anyone else, feel it necessary to talk down the future. This is very discouraging. But it gets worse. All of this refers to profits. In Europe, companies excluding financials are expected to see earnings decline 1.2 per cent - while revenues decline by a thumping 5.7 per cent. In the US, most S&P 500 companies announced sales below forecasts, and overall fourth quarter sales feel 3.8 per cent. Technology companies' sales were down 4.1 per cent. But it gets worse when we look further into the future. Tobias Levkovich of Citi estimates that US long-term earnings expectations have fallen to a 50-year low, with longterm multiples implying earnings growth of less than 4 per cent.
And now it really starts to sound bad. So far, we have been using the pro forma numbers publicised by companies and compiled by Thomson Reuters. These numbers often will be more relevant to investors than the official numbers compiled under generally accepted accounting principles (Gaap), with all their assumptions on goodwill from acquisitions, depreciation, and so on. Provided they publish Gaap numbers, US companies have since 2003 been permitted by regulators to publish adjusted numbers that exclude numbers related to specific events.
But the Gaap principles are generally accepted for a reason, and they suggest that US earnings have already been falling for five quarters in succession. The operating numbers suggest that the earnings recession only started in the third quarter of last year. And a report by Morningside Hill Capital Management in New York shows that the gap between Gaap and adjusted numbers had widened, and reflects deliberate manipulation by groups. For 2015, the Thomson Reuters number for earnings was 29.5 per cent above the Gaap number, almost identical to the 28.6 per cent gap that had opened in 2007, on the eve of the crisis. Only two years ago, the gap was as narrow as 9.5 per cent.
Wherein lie the differences? Companies are treating management bonuses and recruitment costs as one-off expenses, even though they are part of the true cost of business. The same is true of regulatory and litigation expenses, and M&A fees. Sometimes, even the effect of currency moves is excluded. It is understandable that in the long run Gaap earnings matter more. As research by Andrew Lapthorne of Societe Generale shows, stocks tend to follow Gaap numbers in the long run, not pro forma profits (or "made up profits" as he calls them). One final note of concern: earnings per share under Gaap have themselves been boosted by share buybacks and M&A. As these have to an extent been funded by cheap debt, even Gaap earnings look extended.
How does this feed into the market? The bounce from the new year sell-off has now continued for two weeks, for the good reason that the last two weeks of US economic data has come in better than expected, dampening recession fears. This should limit the "downside" to the market. But it would be unwise to expect the market to recoup all its losses and breach the record high set last spring. Stocks are expensive.