The Earnings Recession Has Already Begun
Sep 11th 2012 3:55PM
Updated Sep 11th 2012 4:00PM
I've expressed concern regarding the sustainability of U.S. company profit margins for more than two years now. Since then, the leading companies have made me look like the boy who cried wolf as margins continued to expand. That performance has been impressive, but I don't see how it can be maintained. In fact, a reversal now looms large, with third-quarter earnings for the S&P 500 (INDEX: ^GSPC) expected to fall relative to the second quarter, while 2013 estimates that look impossibly optimistic. That's an unlikely backdrop for significant and sustainable gains in stock prices over the next several quarters.
What goes up must come down
The following graph shows the trailing-12-month profit margins for the S&P 500 from the fourth quarter of 2000 through June of this year. The blue line tracks the profit margin based on operating earnings, while the green line is based on "as reported" earnings (the former is less volatile because operating earnings exclude "unusual" items):
Source: Author's calculations; S&P Dow Jones Indices.
Source: Author's calculations; S&P Dow Jones Indices.
Margins are now at a cyclical high, if the last 12.5 years are anything to go by. At 9.5%, the most recent figure is above the 2006 peak of 9.3% observed during the previous cycle. Furthermore, in 2006 and 2007, profit margins were artificially inflated for a number of reasons.
Nothing succeeds like excess
First, companies were repurchasing shares at a furious pace, thereby reducing the share count and boosting earnings per share; buybacks totaled $432 billion in 2006 and an extraordinary $589 billion in 2007. By comparison, the annual total last year was $405 billion; since then, the quarterly total has declined in both the first and second quarter of this year.
In the previous cycle, the S&P 500's margins were also inflated due to the profitability of financials, which was not simply at a cyclical high, but at an extreme, bubble-driven high. A multiyear process of "financialization" of the economy had reached its peak, and the financial sector's largest institutions were achieving extraordinary returns on equity, fueled by securitization profits.
In that context, current corporate earnings look vulnerable. UBS strategist Jonathan Golub warned last week that we are now entering an "earnings recession":
Looking at earnings growth (i.e., without the impact of shrinking share counts) excluding prior-period Financial sector writedowns, we see an outright earnings contraction.
More specifically, earnings for the S&P 500 ex-Financials declined by 1.5%, while revenues were down 0.2%. Notably, we exclude Financials because the sector's results are often skewed by one-time items and debt valuation adjustments, which mask the broader earnings trend. ... Further, consensus estimates are calling for EPS growth to go negative in 3Q12 -- falling to $25.07 from $25.65.
As Golub rightly points out, the S&P 500's earnings are now expected to dip in the current quarter:
Operating EPS* (bottom-up)
Source: Author's calculations; S&P Dow Jones Indices. *Q3 2012 and Q4 2012 figures are estimates. **With 99.2% of companies having reported.
On Sept. 4, FedEx (NYS: FDX) reduced its guidance for its fiscal first quarter ended Aug. 31 from a range of $1.45 to $1.60 to between $1.37 and $1.43, citing "weakness in the global economy." FedEx's rival United Parcel Service (NYS: UPS) had already guided lower for the second half of the year in July. At the end of August, data provider Factset reported that the proportion of companies that had given negative guidance for the third quarter was on track to be the highest since the firm began tracking this figure in Q1 2006.
How did we get here?
The real problem isn't 2012 earnings estimates, however; it's those for 2013. Third- and fourth-quarter estimates have fallen consistently this year and are now 8% and 5% lower, respectively, than they started the year. Meanwhile, the 2013 EPS estimate is 8% higher than it was at the beginning of the year. How did that happen? Let's see how it has evolved this year, quarter by quarter:
|Dec. 30, 2011||$106.87||--|
|March 30, 2012||$117.91||10.3%|
|June 29, 2012||$117.75||(0.1%)|
|Aug. 31, 2012||$115.30||(2.1%)|
Source: S&P Dow Jones Indices.
During the first quarter, while analysts were lowering their estimates for the second half of 2012, they were simultaneously raising next year's estimate -- for an aggregate increase of 10.3%! Had the outlook for businesses worsened for the back half of this year while brightening for 2013?
I think there is a simpler explanation: The first-quarter rally lifted the S&P 500 by 12% -- the best first-quarter performance since 1998. Rising stock prices prompt analysts to raise their price targets in order to keep up with, or stay ahead of, the market's drumbeat. Raising 2013 earnings estimates was a straightforward and low-commitment way to justify higher stock valuations and price targets.
Will stocks get schooled?
The summer break is over, the economic and policy environment remains highly uncertain, and growth will be hard to come by. All data shows a material slowdown in China, European policy cooks still disagree on the right recipe for the euro-broth, and the U.S. recovery continues to underwhelm. The optimism of the first quarter has evaporated, and analysts are grudgingly bringing down 2013 EPS estimates -- but not fast enough. No wonder Morgan Stanley's chief U.S. equities strategist, Adam Parker, said 2013 margins were "a problem" last week, expounding: "If the revenue estimates are right, the earnings expectations are way too high."
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The article The Earnings Recession Has Already Begun originally appeared on Fool.com.Fool contributor Alex Dumortier holds no position in any company mentioned. Click here to see his holdings and a short bio; you can follow him @longrunreturns. Motley Fool newsletter services have recommended buying shares of FedEx. The Motley Fool has a disclosure policy. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. Try any of our Foolish newsletter services free for 30 days.
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