Mar­kets don’t seem to have fac­tored in the bad news

The Pak Banker - - OPINION - John Authers

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.

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