Q3 2014 Earnings Breakdown – Do You Still Believe In Miracles?

With the third quarter earnings reports for the S&P 500 now in, I can update my quarterly analysis of earnings and estimate trends through the 3rd quarter of 2014.

Third quarters results were improved over Q2 as activity continued its rebound following the exceptionally cold winter season.  For the quarter, operating earnings rose from $29.34 per share to $29.75 which translates into a quarterly increase of 1.4%. While operating earnings are widely discussed by analysts and the general media; there are many problems with the way in which these earnings are derived due to one-time charges, inclusion/exclusion of material events, share buybacks and accounting gimmickry to "beat earnings."

Therefore, from a historical valuation perspective, reported earnings are much more relevant in determining market over/undervaluation levels. On a reported basis, earnings improved from $27.14 to $27.64 or 1.84% from the first quarter.

The rise in both operating and reported earnings for the quarter brought the trailing twelve months earnings per share to $114.66 from $111.83, a 2.53% increase, on an operating basis. The trailing twelve month reported earnings rose by $3.01 from $103.12 to $106.13, an increase of 2.92%.

Importantly, the rebound in Q3 earnings is consistent with the rebound/slowdown recovery that has been the hallmark of the economic cycle following the financial crisis. Historically, these large rebounds in earnings have tended to be one-quarter events followed by a marked slowdown in subsequent growth rates. 

However, while the headline earnings numbers were strong in the third quarter; digging into the details revealed a bit more troubling picture.

Always Optimistic

There is one commodity that Wall Street always has in abundance, "optimism." When it comes to earnings expectations, 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 compares economic growth (forward projections are at 2% annualized) to earnings growth. Wall Street has always extrapolated earnings growth indefinitely into the future without taking into account the effects of the normal economic and business cycles.  This was the same in 2000 and 2007. Unfortunately, the economy neither forgets nor forgives.

With estimates once again in the stratosphere, and not one Wall Street analyst expecting a recession at any point the future, it is only a function of time until the next major reversion occurs. To visualize the current extremes in earnings estimates, we can view the long term cyclicality of earnings. As shown in the next chart, earnings tend to cycle regularly between 6% peak to peak and 5% trough to trough growth in earnings. With 2015 expectations exceeding the current 6% peak to peak growth rate, it is only a question of what will trip up this overly optimistic picture.

As I wrote in "Not All That It Seems," the drivers behind the growth in earnings are not entirely organic.  I have extended the chart to 2020 showing Jeff Saut's recent extrapolated earnings growth trend. The idea of "permanent liquidity," and the belief of sustained economic growth, despite slowing in China, Japan and the Eurozone, has emboldened analysts to push estimates of corporate profit growth of 6% annually through 2020. Such a steady rise in earnings per share would push levels to more than $183.00 per share. The problem is that such an earnings expansion has never occurred in history as it completely disregards the course of normal business and economic cycles.

The problem with forward earnings estimates is that they consistently overestimate reality by roughly 33% historically. The chart below shows the consistently sliding revisions of analyst expectations versus the reality of corporate profitability. At the beginning of 2012, it was estimated that by Q4 of 2013 reported earnings would reach $106.16. However, 2013 ended at just $100.20 as the economy failed to recover as expected. Despite a more dismal outlook in corporate earnings, stock prices have rocketed higher from the continued interventions from Central Banks globally.

Currently, estimates for the end of 2014 have once again began to get knocked down. At the beginning of 2013 it was estimated that 2014 would end at $121.40 versus the June, 2014 estimate of just $114.39. However, just three months later, the 2014 year-end estimate has been reduced to just $110.10. Currently, as of the end of November, that year-end estimate is sitting at $109.67 as economic growth has once again failed to materialize as expected.

Currently, year-end 2015 estimates are at almost $135 on a reported basis which suggests that earnings will surge by 23% in the next twelve months. Decisions made today, based on those expectations, will most likely lead to overpaying for investments as forward estimates are lowered to meet with economic realities in the months ahead.

Given that earnings are what investors are pay for, the price of the market should be a reflection of earnings growth over time. As shown below, the S&P 500 has tended to somewhat "lag" peaks in earnings growth. However, due to the massive interventions by Central Banks, asset prices have run well ahead of earnings growth expected into 2015. Furthermore, the deviation in earnings from the long-term growth trend are at levels never witnessed before in history.

With prices well ahead of expectations, and expectations well deviated from historical norms, it is unlikely that this ends well.  While there are many that suggest that "this time is different" due to accounting changes, Central Bank stimulus, and low interest rates, history suggests this unlikely to be the case.

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 has increased by a total of 268%. This is the sharpest post-recession rise in reported EPS in history. The issue is that the sharp increase in earnings did not come from a similar surge in revenue that is reported at the top line of the income statement. Revenue from sales of goods and services has only increased by a marginal 33% during the same period.

In order for profitability to surge, despite rather weak revenue growth, corporations have resorted have resorted to using debt to accelerate share buybacks. The chart below shows the total number of outstanding shares as compared to the difference between operating earnings on a per/share basis before and after buybacks.

However, companies are not just borrowing to complete share buybacks but also to issue out dividends. According to the most recent S&P 500 company filings, the level of cash dividends per share has now reached $10.02 which is the highest level on record. It is also the greatest deviation from the long-term trend of dividends per share since the financial crisis (highlighted in blue.)

The reality is that share buybacks 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, share buybacks and cash dividends provide the basis to keep Wall Street satisfied, and stock option compensated executives and large shareholders 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 underpinnings of current earnings growth are 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 that uptick in the economic data is crucially important if the economy is indeed turning a corner toward stronger growth. Unfortunately, with deflationary pressures rising in the Eurozone, Japan and China, the Affordable Care Act about to levy higher taxes on individuals, and labor slack remaining stubbornly high 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 being lowered further in the coming months ahead as stock buybacks slow and corporate cost cutting becomes less effective.