by Lance Roberts
With 99% of the S&P 500 earnings reported (as of Aug.30, 2013) we can now take a closer look at the results for the first half of the year. Operating earnings rose from $25.77 per share to $26.36. While operating earnings are widely discussed by the media there are many problems with the way in which these earnings are derived. Therefore, from a historical valuation perspective, reported earnings are much more relevant in determining market over/under valuation levels. In this regard reported earnings increased from $24.22 to $24.95 per share in the second quarter. Trailing twelve month earnings per share rose from $98.35 to $99.28 for operating earnings and from $87.70 to $91.03 for reported earnings. However, while the headline reports were certainly encouraging - digging into the details revealed a bit more troubling picture.
Always Optimistic
There is one commodity that Wall Street always has in abundance and that is "optimism." When it comes to expectations for corporate earnings the 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. In a recent missive entitled the "4 Tools Of Corporate Profitability" I stated:
"There is no doubt that corporate profitability has surged from the recessionary lows. However, if I am correct in my assessment, then the recent downturn in corporate profitability may be more than just due to an economic "soft patch." 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. While Goldman Sachs expects profits to surge in the coming years ahead - history suggests something different."
The chart below shows the consistently sliding revisions as of late in corporate profitability. At the beginning of 2012 it was estimated that by Q4 of 2013 reported earnings would be $106.16. In March of 2013 the Q4 estimate had been dropped to $99.75 even as stock prices were boosted by continued injections from the Federal Reserve. Currently, as the end of the year rapidly approaches, estimates have been knocked down to just $97.30 as slower economic growth has weighed on profitability.
This is the primary problem of using "forward" estimates as a valuation tool. The always overly optimistic assumptions leads to faulty analysis as sliding earnings leads to sharp valuation increases. The chart below shows the progression of forward P/E estimates since the beginning of 2012. Currently, with the S&P 500 valued at 19x reported earnings it is hard to justify that the market is undervalued.
Accounting Magic
What has also been stunning is the surge in corporate profitability despite a lack of revenue growth. Since 2009 the reported earnings per share of corporations, the bottom line of the income statement, have increased by a total of 222% which is the sharpest, post-recession, increase in reported EPS in history. However, at the same time, reported sales per share, which is what happens at the top line of the income statement, has only increased by a marginal 22% during the same period. This is shown in the chart below.
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 create a mirage of corporate profitability. The problem, however, is that each of these not only have a negative economic consequence but also suffer from diminishing rates of return over time.
One of the primary tools used by businesses to increase profitability has been through the heavy use of stock buy backs. The chart below shows outstanding shares as compared to the difference between operating earnings on a per/share basis before and after buy backs.
The problem with this, of course, is that stock buy backs 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.
As I discussed at length in my recent report on "Evaluating 3 Bullish Arguments:"
"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 rising interest rates will slow 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."
The ongoing deterioration in earnings is something worth watching closely. The recent improvement in the economic reports is likely more ephemeral due to a very sluggish start of the year that has led to a "restocking" cycle. The sustainability of the uptick is crucially important if the economy is indeed truly turning a corner toward stronger economic growth. However, with interest rates rising, oil prices surging and the Affordable Care Act about to levy higher taxes on individuals, it is likely that a continuation of a "struggle" through economy is the most likely outcome. This puts overly optimistic earnings estimates in jeopardy of be lowered further in the coming months ahead as stock buybacks slow and corporate cost cutting continues to become less effective.
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