In a market in which “one-time, recurring adjustments” such as JPM’s quarterly (and quite recurring) multi-billion addbacks consistently mean the difference between meeting and beating expectations for corporations, one long-forgotten aspect of earnings is what net income would be on a plain-vanilla, GAAP basis: the kind which actually looks at the true bottom line excluding accounting gimmicks, pro forma fabulations and recurring non-recurring adjustments. As the chart below shows, GAAP EPS in the just completed third quarter declined from a record high $26.13 in Q2 to $23.85.
The good news: while GAAP earnings declined on a sequential basis, they increased by 9% compared to last year. However, what is quite visible in the quarterly EPS chart below is the increasingly declining power of Fed intervention to keep earnings rising: the surge impact of QE1 faded in 3 quarters, QE2 rolled over in March 2012, and QE3 didn’t really generate a big boost in earnings until the arrival of Japan’s QE in Q2 of 2013, although even that now appears to be rolling over.
GAAP EPS on a quarterly basis:
Same as above shown on a trailing 12 month basis:
So just how is the rolling over – on a normalized, actual basis – market supposed to be cheap? Simple: margins that are expected to literally go parabolic in the coming years. How? It is unclear because with most companies having already “temped out” and converted what full-time workers they have to part-time, and fixed costs only expected to rise once the must delayed inflation eventually does make a return appearance, the only place for margins is down. In any case, here is the expectation:
Which leaves just one possibility: even more multiple expansion. There is one problem: multiple growth has already been thoroughly abused as a source of stock market “growth”, and accounts for over 80% of the market upside in the past two years, and is responsible for 75% of the S&P increase in 2013. Excluding the 2009 “outlier” event, this is the greatest contribution to the S&P from multiple expansion in 15 years.
Putting this all together, what does the true earnings picture of companies tell us about the market? Simple: it is overvalued relative to historical averages on every single basis, and not just the much discussed recently 10 year average used in the Shiller PE which has the market now at a 25x multiple.
Or in table format:
In short: the trailing EPS of 18x GAAP and 16.3x Non-GAAP is higher than the comparable GAAP and non-GAAP multiple for the long term, 1910-2013 average (15.8x and 14.5x), and while in line with the GAAP average for the 1960-2013 period, it is overvalued relative to the 15.9x non-GAAP average. However, if one excludes the 1997-2000 tech bubble, the historical average multiples drop even more to 17.7 and 15.2.
The one loophole: the high inflation years (1974-1984), when PE multiples were below 10x for both GAAP and non-GAAP. Then again, as the market has priced in the high inflation courtesy of the Fed’s exploding balance sheet, which however has yet to manifest itself in the economy and soaring input costs. So assuming a trendline EPS of ~$100 and applying a “high inflation” multiple of 10x to it, leads to the same conclusion recently observed by Jeremy Grantham’s GMO: the market is about 75% overvalued.
Deutsche Bank’s David Bianco had a succinct summary of the above quandary:
Growth is all that matters now
We find ourselves in a very cheery early holiday mood. 1800 certainly deserves celebration. Whether 2013 ends with the S&P +/- 50 points from here matters little. This year will be remembered for strong gains, investors putting the crisis behind and restoring the normal S&P PE. This is a welcome sign of better confidence and equity wealth helps, but before we get too merry we turn to the simple truth that now good growth better come. An accommodative Fed, buybacks, inflows, not expensive PE (despite Shiller’s PE) will all assist the market in 2014, but healthy EPS growth is now a must…. We think S&P EPS growth must be 7-9% next year to meet today’s price implied expectations.
Unfortunately for growth to materialize, there has to be investment in the future, capex spending, revenue upside and ultimately EPS growth. However, as we predicted nearly 2 years ago and as proven correct subsequently, in the new normal, CapEx is the last thing on any corporation’s mind. Proof: the latest core capital spending report:
So good luck with that 7-9% EPS growth, especially if Barack Obama is indeed hell-bent on converting banks into utilities courtesy of billions in quarterly “non-recurring” litigation charges.
In conclusion we should note that all of the above is moot – as long as the only driver of stock prices is the Fed’s surging balance sheet, which for now shows no indication of slowing down, any comparative analysis of the New Normal to prior historical periods is completely meaningless.
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