Have Earnings Become Irrelevant for S&P 500 Companies? Monster Bubble vs Depression?

By the Curmudgeon

According to a February 23^rd email from “Mitch on the Markets” of Zacks, total 2019 earnings (or aggregate net income) for S&P 500 companies was expected to be down -1.5%. While S&P companies made less profit in 2019 compared to 2018, the S&P 500 index was up +31.49% last year. In that same email, Zacks says “there may not be anything wrong with this picture,” i.e. stocks soaring while year over year earnings growth is negative. So much for the maxim that earnings growth drives stock prices?

In a recent FactSet post, John Butters noted that as of February 19^th, that analysts were projecting record-high EPS for the S&P 500 of $175.97 in CY 2020 and $195.88 in CY 2021 on February 19^th. Yet in a Feb 21^st post, FactSet says that for Q1 2020, 61 S&P 500 companies have issued negative EPS guidance while 28 S&P 500 companies issued positive EPS guidance. That is more than a 2:1 ratio of negative to positive earnings guidance and does not augur well for 2020 earnings.

But who cares if earnings are no longer driving stock prices? This irrelevance can be seen in the increasing S&P 500 P/E ratio. On February 19^th, the forward 12-month P/E ratio for the S&P 500 was 19.0 (the S&P 500 closed at a record-high value of 3386.15 on that date). That marked the first time the forward 12- month P/E had been equal to (or above) 19.0 since May 23, 2002 (19.1).

Note that S&P 500 earnings estimates for all of the last several years have been way too high and get ratcheted down as the year progresses. DoubleLine’s Jeff Gundlach has repeatedly called attention to that fact during his webcasts.

Also, the referenced record high earnings estimates do not take into account the negative effects of the coronavirus on supply chains and earnings OR global economic weakness that’s been apparent in the first two months of 2020. If the latest S&P 500 earnings estimates were more realistic (e.g. SIGNIFICANTLY LOWER), the S&P 500 P/E ratio would be a lot higher than 19!

Finally, earnings per share (EPS) – the denominator of the P/E is HUGELY distorted due to stock buybacks which shrink the number of shares outstanding. If aggregate earnings were used for the P/E calculation, it would surely be much higher.

Let’s take a look at how the latest FactSet 19.0 P/E ratio compare to historical averages of S&P 500 P/Es:

S&P 500 Forward 12 month PE ratio

Chart courtesy of FactSet

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Butters notes that in the one year prior (February 20, 2019), the forward 12-month P/E ratio for the S&P 500 was 16.2. Over the following 12 months (February 20, 2019 to February 19, 2020), the price of the S&P 500 increased by 21.6%, while the forward 12-month EPS estimate increased by 4.1%. Thus, the increase in the “P” has been the main driver of the increase in the P/E ratio over the past 12 months.

That begs the first question posed in the title of this article: Are earnings (and especially earnings growth) no longer relevant in forecasting stock prices?

For years, Victor and I have tried to address that question by saying “the rules have changed” or “the old (time tested) rules no longer apply.” That is mainly because of the Fed’s ultra-easy monetary policies as well as those of other central banks. Stock buybacks as a source of demand for stocks that shrinks the supply is another important factor.

Charles Hugh Smith summed it all up in his blog post titled: The Fed Has Created A Monster Bubble It Can No Longer Control. Here’s a picture that’s worth a thousand words:

Here are a few excerpts from the article that we especially liked:

History has never recorded a bubble which settled magically onto a "permanently high plateau" and stayed there for months or years. So the Fed has finally reached the point of no return: either it accepts a painful bursting of the monster moral-hazard bubble it has created or it lets the monster lead the stampede over the cliff to a financial collapse that the Fed can't rescue with the usual tools of lowering interest rates and bailing out banks……

Even the hubris-soaked fools in the Fed realize this bubble has disconnected from financial realities. There's a phrase for this: disconnect from reality, all driven by the manic certitude that the Fed will never let stocks fall ever again - ever!

At this point, the Fed will be hoist on its own petard: by claiming god-like control of interest rates, financial markets and the economy, the Fed must now accept responsibility for what happens in the end-game of the Moral-Hazard Monster Bubble it created: either allow a 25% to 30% wipeout of speculative excess now or feed the final stampede to financial collapse.

In a February 23^rd post, Mr. Smith asks: When Will We Admit Covid-19 Is Unstoppable and Global Depression Is Inevitable? Smith opines that it doesn't take much to break a system dependent on ever-rising debt and speculation. This chart illustrates the dynamic: when debt loads, speculative bets and expenses are all at nosebleed levels, the slightest decline triggers collapse. The global system has been stripped of redundancy and buffers. A little push is all that's needed to send it over the edge.

In an austere conclusion, the author states:

Given the exquisite precariousness of the global financial system and economy, hopes for a brief and mild downturn are wildly unrealistic. The global economy is falling off a cliff and calling it a "recession" while debt and speculative excesses collapse is a form of denial.

When debt and speculative excesses collapse, it's a depression, not a recession. If we can't call things by their real name then we guarantee a wider, deeper cataclysm.

We certainly hope Mr. Smith is wrong about a depression in our future. Most pundits don’t even see a recession in 2020 or 2021!

Closing Quotes:

“Equity markets are looking increasingly exposed to near-term downward surprises to earnings growth,” Oppenheimer, chief global equity strategist at Goldman, wrote in a Feb. 19 note. “While a sustained bear market does not look likely, a near-term correction is looking much more probable.”

“In the context of relatively weak earnings growth, there’s probably too much complacency and we could see some negative earnings,” said Oppenheimer in an interview with Bloomberg TV on Tuesday. “And valuations are vulnerable to a setback.”

AdMacro’s Patrick Perret-Green told CNBC Tuesday that the markets were being “far too casual” given the growth of China’s economy since 2003, along with the increase in its urban population and accessibility of travel. He said the coronavirus outbreak represented a “Lehman-type moment tipping point” which could “tip the global economy into effective recession.”

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Good luck and till next time….

The Curmudgeon
ajwdct@gmail.com

Follow the Curmudgeon on Twitter @ajwdct247

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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