Earnings Recession Continues; Severe Decline in Core Earnings Explained
By the Curmudgeon
In our last post - Curmudgeon: S&P 500 Earnings Beat Estimates Which Continue to Fall; ShadowStats Financial Forecast (11/11), we noted that S&P 500 companies had reported what looked to be three consecutive quarters of negative earnings growth. That was confirmed last Thursday, November 21st by FactSet, which stated that the S&P 500 (combined average of 500 companies) reported a decline in earnings of (-2.2%) for the third straight quarter. That was the largest earnings decline so far this year. Note also, that 85 S&P 500 companies issued negative EPS guidance for Q3 tied for third highest number since 2006. But thats old news!
What about 2019 Q4 earnings for the S&P 500?
Lipper (owned by Reuters) reported on Friday November 22nd that there have been 61 negative EPS pre-announcements issued by S&P 500 corporations for 2019 Q4 compared to 29 positives, which results in a Negative/Positive ratio of 2.1 for the S&P 500 Index. Sanguinely, Lipper estimates earnings growth rate for the S&P 500 for 2019 Q4 to be flat (0.0% growth). FactSet disagrees.
Earnings for the S&P 500 companies are now projected to decline 1.51% in the fourth quarter from the year before, according to a FactSet compilation of analysts average forecasts for individual companies making up the S&P 500. The last time S&P 500 corporate earnings decreased for four quarters in a row was in the period beginning with the third quarter of 2015, according to FactSets senior earnings analyst John Butters.
An earnings recession is defined as two quarters or more of consecutive year-over-year declines. Weve now experienced three such negative quarters with the Q4 forecast to be flat to down 1.51% depending on the forecast.
Heres an interesting chart from Refinitiv:
S&P 500 Y/Y Growth Rates:
You can clearly see that S&P 500 revenues, net income and earnings peaked in 2018 Q3, began declining through 2019 Q3 (this past quarter). The numbers starting with 2019 Q4 are forecasts, which are subject to drastic revisions. For example, 2019 Q4 earnings are now estimated to have grown 0.0% (Lipper) vs the 3.9% (Refinitiv) shown in the above table. That discrepancy is because the chart and table forecasts have not yet been revised downward!
Earnings Recessions vs. Economic Recessions:
Three-fourths of earnings recessions since World War II have morphed into economic recessions, according to CFRA Chief Investment Strategist Sam Stovall, who has been scratching his head trying to reconcile analyst pessimism around earnings with continued stock-market rallies. The S&P 500 has hit 10 new all-time highs since Oct. 28th, but during that entire time, earnings forecasts have been coming down, Stovall noted. While third-quarter earnings did fall, the decline wasnt as steep as what analysts had originally projected, marking the 31st straight quarter when actual profits exceeded end-of-quarter estimates.
Of course, that is the managed earnings game corporate CFOs play with stock market analysts. The result is that a YoY earnings decline becomes an earnings beat, (due to fake lower earnings guidance) which sparks a rally in the stock price. What a sham!
Core Earnings Distortion Missed by Most Investors/Speculators:
Heres an illuminating Q&A and chart from MarketWatch:
The S&P 500 index has been on a tear this year, up nearly 25% and currently around an all-time high.
How do stocks rise when the underlying fundamentals fall?
Answer: Most investors are not aware of the more severe decline in core earnings.
Why are they not aware?
Answer: Because too few people read the footnotes.
Adjusted core earnings drop below GAAP earnings for the first time since 2006: Over the trailing 12 months, GAAP earnings fell 1% while adjusted core earnings fell 6% for the largest 1,000 companies by market capitalization in each period. Most investors know that GAAP earnings are prone to distortion because they include lots of non-recurring or unusual items.
Most investors are not aware that core earnings (from CompuStat or Wall Street analysts) are also distorted by unusual items. In fact, earnings for the S&P 500 were distorted by 22% on average in 2018.
The chart below highlights the more severe drop in core earnings when accounting for these hidden gains or losses.
Earnings distortion from hidden gains is on a rapid rise, and core earnings from traditional sources have not been this overstated since 2000. The rapid rise in earnings distortion since 2015 means that an increasing amount of corporate income is coming from unusual or one-time gains, which is not apparent to investors analyzing news releases or income statements. Corporate managers hide the one-time nature of these gain by only disclosing them in the fine print. In other words, managers are dressing up the numbers in an increasingly aggressive manner over the last few years.
In Stovalls view, trade fears have analysts feeling cautious about profits even as the market seems to be anticipating that things could get better. Until details of the deal are revealed, along with the prospects for continued conversations, EPS estimates are likely to undershoot potential, he wrote in a recent note to CFRA clients.
Some of the downward earnings forecasts are huge. Amazon, typically a big winner in holiday sales and the undisputed cloud computing leader, is expected to post an earnings decline of 31.3% in the fourth quarter, after earlier projections called for an 8.3% advance. The e-commerce and cloud computing giant increased spending this year to cut its delivery times to Amazon Prime customers in half (to one day), and all retailers face a shortened shopping season this year with Thanksgiving falling later in the calendar. That does not augur well for corporate profits in the retail sector.
Because the S&P 500 is market-cap weighted, profit declines at large companies have an outsize impact on overall earnings for the index. A handful of large companies that have been big contributors to the earnings decline thus far in 2019 are expected to deliver sizable drops in profits for the fourth quarter. In addition to Amazon, others include Boeing, Exxon Mobil and Micron Technology.
FactSets Butters notes that 2019 Q4 estimates call for larger earnings declines among companies with greater international exposure. Thats because of the very weak global economy and the high value of the US dollar vs. foreign currencies. For S&P 500 components that generate more than half of their revenue internationally, the average projection is for a 3.9% drop in profits as of November 20th. Earnings are expected to be flat for those companies that derive more than half of their revenue domestically.
CFRAs Stovall said that a U.S. China trade deal would offer some relief to multinational sectors, including industrials, materials, and technology, which also happen to be cyclical industries. But of course, that depends on the nature of the deal and how much is genuine vs PR fluff.
There must be a lot of hopes pinned on relaxation of tariffs from a trade agreement as the stock market rallies on ANY keywords indicating theres a positive outlook for such a trade deal. Weve been surprised that these rallies have been going on unabated (including last Friday, November 22nd) without any trade resolution accomplished or even scheduled. Evidently, thats the nature of the Alice in Wonderland markets we live in today.
For those who think stock market bull/bear cycles have been repealed and we are in a never ending bull market with no recessions for the next 10 years, heres a quote for you:
You get recessions, you have stock market declines. If you don't understand that's going to happen, then you're not ready, you won't do well in the markets.
By Peter Lynch, former manager of Fidelity Magellan fund.
Good luck and till next time
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Curmudgeon is a retired investment professional. He has been involved in financial markets since 1968 (yes, he cut his teeth on the 1968-1974 bear market), became an SEC Registered Investment Advisor in 1995, and received the Chartered Financial Analyst designation from AIMR (now CFA Institute) in 1996. He managed hedged equity and alternative (non-correlated) investment accounts for clients from 1992-2005.
Victor Sperandeo is a historian, economist and financial innovator who has re-invented himself and the companies he's owned (since 1971) to profit in the ever changing and arcane world of markets, economies and government policies. Victor started his Wall Street career in 1966 and began trading for a living in 1968. As President and CEO of Alpha Financial Technologies LLC, Sperandeo oversees the firm's research and development platform, which is used to create innovative solutions for different futures markets, risk parameters and other factors.
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