Courtesy of Lance Roberts of STA Wealth Management
Earnings Recession Deepens
"If you just exclude all the bad stuff, earnings look quite good."
This has been the primary rhetoric by mainstream analysts during the past quarter's earnings reporting season. It is true. If we just take out the impact of the rising dollar, falling oil and commodity prices, weak consumer spending, and the inability of rampant stock buybacks to boost bottom line earnings, reports have not been that bad.
However, the reality is that the decline in earnings, and particularly the decline in forward earnings estimates, suggests that something more pervasive is happening in the economy. As noted by Political Calculations this past week:
"In the chart above, we confirm that the trailing twelve-month earnings per share for the S&P 500 throughout 2015 has continued to fall from the levels that Standard and Poor had projected they would be back to in August 2015. And for that matter, what they forecast they would be back to in May 2015, February 2015 and in November 2014.
The deterioration in the S&P 500's earnings per share has finally drawn the attention of Reuters, which notes that the earnings of U.S. companies in the third quarter, which were just reported, were the first to be outright negative as opposed to being less and less positive.
The previous recession in the S&P 500's trailing year earnings per share, which ran from 2012-Q2 through 2013-Q1, coincided with economic growth in the U.S. economy stalling out to near-zero levels, a fact that has become more and more apparent with each year's comprehensive revisions to the nation's GDP, where estimates of the real growth rate have been consistently reduced below their originally reported figures.
The current trailing year earnings recession is of a considerably greater magnitude. We would, therefore, expect to see larger downward revisions in estimated GDP growth for the period from 2014-Q4 through at least 2016-Q1 as the U.S. Bureau of Economic Analysis' annual GDP revisions are released."
This is exactly correct. The problem with analysis that just suggests "excluding energy," obfuscates the importance of the energy sector across the economic landscape. For example:
- Energy-related capital expenditures account for almost 1/4th of all CapEx
- Jobs created in the energy sector are some of the highest wage paying jobs
- Energy operations have a large multiplier effect overall from trucking to shipping, retail, support, and a vast variety of service-related industries from lodging to telecommunications.
The point here is that while excluding earnings declines in the energy sector makes the rest of the earnings look better, the negative impact to the overall economy from the energy sector should not be dismissed.
But it isn't just earnings reports that are worrisome.
Net Profits And Reversions
As Jeremy Grantham once stated:
"Profit margins are probably the most mean-reverting series in finance, and if profit margins do not mean-revert, then something has gone badly wrong with capitalism. If high profits do not attract competition, there is something wrong with the system, and it is not functioning properly."
Grantham is correct. As shown, when we look at inflation-adjusted profit margins as a percentage of inflation-adjusted GDP we see a clear process of mean reverting activity over time.
Reversions occur both from peaks and troughs. Therefore, when profits-to-GDP have exceeded their long-term average to a significant degree (1 or 2 standard deviations), there has always been a subsequent reversion. (Note: the chart above is real, inflation-inflation adjusted profits to real GDP.)
Corporate profit margins have physical constraints. Out of each dollar of revenue created there are costs such as infrastructure, R&D, wages, etc. Currently, one of the biggest beneficiaries to expanding profit margins has been the suppression of employment and wage growth and artificially suppressed interest rates that have significantly lowered borrowing costs. Should either of the issues change in the future, the impact to profit margins will likely be significant.
However, there is one more fascinating tale that the inflation-adjusted profits-to-GDP ratio tells us. The chart below shows the ratio overlaid against the S&P 500 index.
I have highlighted peaks in the profits-to-GDP ratio with the blue vertical bars. As you can see, peaks, and subsequent reversions, in the ratio have been a leading indicator of more severe reversions in investment markets over time. This should not be surprising as asset prices should eventually reflect the underlying reality of corporate profitability. However, since asset prices are driven by emotion, rather than logic, this accounts for the lag between the fundamentals and the realization by investors "this time is NOT different."
As stated above, balance sheet manipulations have been the primary factors in surging profitability. However, those actions are finite in nature, and the process of manufacturing profits has cannibalized consumer incomes. Stagnant wage growth, combined with a rising cost of maintaining the current standard of living, has led to a diminishing ability to generate further sales gains in excess of population growth. This goes a long way to explaining why falling gasoline prices, which does not increase real incomes, has not translated into higher retail sales.
The current decline in net profit margins is an early warning sign being readily dismissed. However, while investor appetites for risk remains robust in the short-term, history suggests that such "willful blindness" has led to particularly bad outcomes.
Rates To Remain Low
Simon Constable penned this past week:
"Interest rates are partly a function of inflation expectations, but also depend on how fast investors think the economy will grow.
In fact, the deflationary pressure, or the push down on prices of goods and services as well as wages, may overwhelm and push interest rates even further lower. The stronger dollar is great for consumers, but it also means inflation is being kept down as well.
On the other side of the situation, with the U.S. economy growing relatively slowly (at least by historical standards) there is little room for the cost of borrowing to increase before it starts to weigh heavily on the housing market and then the broader economy."
The chart below proves his point. The economic composite is comprised of wages, inflation, and economic growth which, not surprisingly, have a very high correlation to the trend of interest rates. Since interest rates are ultimately a function of the demand for credit within an economy, without an increase in the components that drive the demand for credit, rates will remain under pressure.
We can also look at it from an inflation standpoint. There are three legs to inflation: 1) Commodity prices which are a reflection of actual economic activity, 2) the velocity of money, or how fast money is flowing through the system from the banks to small businesses and ultimately consumers, and; 3) wage growth. When we combine those components into a singular index, it also suggests there is little support for higher rates currently.
In fact, as Simon noted, there is currently more of a deflationary binge in the economy that suggests the economy is weaker than the Federal Reserve currently forecasts. Of course, as I have stated previously, the Federal Reserve's track record of economic predications has been abysmal.
The problem for bond investors in the years ahead will not be surging interest rates and the collapse of the bond market, but rather the extremely frustrating search for yield and prolonged low-interest rate environment.
Just something to think about.
