The Q2 earnings season has nearly come to an end. The media and most strategists are emphasizing the facts that companies keep beating estimates and that ex-Energy, corporate America continues to lift margins even in the face of tepid top line growth.
Below the surface, however, results are not that great:
- The beat rate, at 73% per Factset, is below the 1-year average (74%) and in line with the 5-year average.
- The surprise percentage (+4.5% above expectations) is in line with the 1-year average and below the 5-year average of +5.0%.
- Earnings surprises declined as the season progressed, averaging 68% for the last 258 companies to report.
- Revenue beats, at 51%, was well below the 1-year and 5-year averages (both 57%).
- The surprise percentage (+0.9%) is equal to the 1-year average but above the 5-year average (+0.7%).
- Thus, given the expectations game corporations play, this last season was average, at best.
But beyond the beats and the surprises, the actual Q2’15 results are displaying a sharp deceleration in revenue and earnings growth rates even when excluding oil as Zacks Research shows:
More importantly, averages are very deceiving in Q2 and are far from providing a realistic picture:
- 46% of S&P 500 companies reported negative EPS growth in Q2 with a median decline of –18.9%.
- The median growth for the 54% of companies with positive EPS growth was +16.2%.
- Ex-Energy, 43% of companies reported negative EPS growth in Q2 with a median decline of –14.6%.
- The two-hump camel is replicated in every sector:
Essentially, half the market has positive EPS growth and half has negative growth, whether you include or exclude Energy.
Zacks Research has a tally for the small-cap Russell 2000 Index:
For the small-cap Russell 2000 index, we have seen results from 1691 index members that combined account for 86.9% of the index’s total market capitalization. Total earnings for these 1691 Russell 2000 members are down from the same period last year -8.1% on +2.6% higher revenues, with 50.7% beating EPS estimates and only 35.7% beating sales estimates.
Russell 2000 Index earnings were up 14.8% YoY in Q1 on revenues up 5.6%. They dropped 8.1% in Q2!
The other problem is raised by Standard & Poors which is the “official” aggregator for the S&P 500 Index earnings database under the leadership of Howard Silverblatt. Howard updates the database as companies report. He subsequently reviews the results after receiving the 10Q reports to make sure that each company results is consistent with S&P’s methodology to ensure uniformity and comparability by company, sector and over time. This is especially critical with respect to special items which companies can define as operating or not but which S&P may classify differently under its own consistent methodology.
S&P’s latest tally dated August 13 puts Q2 operating EPS at $26.22, down $2.24 (7.7%) from the July 30th tally and down 10.6% YoY. In effect, it seems like S&P had to reclassify et recalculate results from many companies in Q2 in order to maintain the integrity of its database from a comparability stand point. Intentionally or not, companies can categorize special items as “operating” or “non-operating” differently than what investors would generally do. S&P tries to ensure consistency.
Interestingly, “operating” EPS were 7.7% above “as reported” EPS during the 7 quarters between Q1’13 and Q3’14. That ratio rose to 17.2% in Q4’14 and 18.3% in Q1’15. We do not have the final number for Q2’15 but we know that 300 of the 458 companies having reported so far had higher “operating” than “as reported” EPS. S&P’s significant downward revisions during the last 2 weeks suggest that more “games” might have been played in the most recent quarter.
Many observers blame energy companies for the more difficult Q2 earnings season. S&P data does not really concur. Among the largest 20 earnings surprises (in terms of their impact on Index earnings), only 3 were positive (+$0.38) and 17 were negative (-$3.43). Five Energy companies account for 47% of the negative surprises but 53% comes from 20 non-energy companies as diverse as Home Depot, Allergan, Wal-Mart, Hewlett-Packard, Medtronic,FedEx, Goldman Sachs, Berkshire Hathaway and Google.
Only four of the 10 largest capitalizations in the S&P 500 Index had positive YoY EPS growth in Q2 and the earnings of the 10 largest companies averaged a 9.4% drop which worsens to –12.6% if we exclude the two outliers (AAPL: +44% and XOM: –51%). Exxon is the only Energy company among this diversified group.
Of the 58 largest S&P companies by revenues ($10B+), 36 (including 3 Energy companies) had positive EPS growth in Q2 with a median gain of 15.3%. Twenty-two companies (including 2 energy companies) had negative growth with a median of –25.0%.
At the other extreme, of the 106 companies with revenues below $1 billion, 51 had positive EPS growth in Q2 with a median growth rate of 17.4%. The other 55 companies had a median EPS decline of –17.9%.
In all, this two-hump camel is just about everywhere in the stock universe whether in large or small caps, energy or not. No wonder U.S. equity averages have been marking time all year long. The half going forward is offset by the half going backward.
As it stands now, S&P trailing earnings are $108.38, down 2.8% from their level after Q1’15 and down 3.1% YoY. Based on S&P’s tally of consensus EPS for Q3, trailing EPS will decline to $107.69 by November before potentially bouncing back to $111.88 after Q4 results are in next March, assuming current Q4 estimates of $30.94, +15.7% YoY, hold.
Will they? BCE Research has a grim view on that:
There is still a dearth of evidence pointing to a reacceleration in global economic growth, despite easy policies abroad. The deflationary weight of deleveraging in Europe and China’s moribund economy are offsetting policymaker’s efforts to stimulate growth.
Although global trade has expanded at roughly twice the rate of world GDP for several decades, the value of exported goods has plunged, warning that corporate sector sales will deteriorate further.
This BCA comment was before China devalued its currency. More volatility and more uncertainty are in store as a result, all things which generally tend to reduce valuations.
More charts to keep you alert:
Yet, many pundits continue to try to justify current equity valuations using forward earnings and arguing that
a 16x multiple on 2016 estimated earnings is actually not that unreasonable (and at the lowest level in four years: maybe analysts are smoking something powerful, but on the chance it is correct then we are not talking about an expensive market at all but one with forward price-to-earnings ratios that are trending down to their lowest level in four years… not to mention below the average of the past three decades). (David Rosenberg)
These past three decades, it must be said, because it should be known to all strategists, included two of the greatest bubble periods in history…
Rosenberg is using 2016 estimates right when the 2015 figure is under severe pressure, conveniently excluding energy from the current results and adding rising energy contributions in 2016 even though oil prices continue to decline.
Why anybody would want to justify buying equities using 2016 estimates at this time is beyond any common sense. Is there one economist who can predict how the world economy will behave in the next 18 months with any degree of confidence?
Even the most well equipped and sophisticated forecasters can hardly predict the next quarter:
The Rule of 20 only uses trailing EPS and trailing inflation. No forecast, no assumptions, no crystal ball. It has proven to be the best and most dependable tool to properly assess the risk/reward equation, not only throughout the current bull market but also throughout the last century.
The Rule of 20 P/E, currently at 20.8, last January finally crossed the “20” line which is the demarcation between undervalued and overvalued stocks. In the past, stocks have had a tendency to rise firmly into the overvalued area after crossing 20, reaching 22-24 on the Rule of 20, suggesting further upside potential but with ever rising risk.
Given the macro headwinds swirling, the growing deflation risks and the increasing evidence that central banks are in a free-for-all mode, it seems appropriate to manage risk down another notch. Recession risks may be low, but “things are getting very complicated” as Ed Hyman recently acknowledged. Overall earnings will not be providing much support for a while and economic growth is erring more toward slower than stronger. In this context, upside potential is no more than 10% (a bubbly 23 on the Rule of 20 with inflation at 1.8% and EPS of $108) while downside is 10-20% (17-19 on the Rule of 20).
Technically, the S&P 500 keeps finding support on its still rising 200-day moving average (2075) and on its 2012-2015 trend line. One should not rest too comfortably on such support, however. Here’s how the trend line provided precious little help in 1987 after confidence suddenly evaporated:
Let’s face it, when valuations are as high as they are, confidence is crucial. Throughout this bull market, central banks were the only sources of confidence for investors. For most of the period, central bankers over the world pushed the pedal to the metal, only to bring world economic growth barely at 2% with deflation still lurking just about everywhere.
Now, each central bank is clearly beating its own drum. The PBoC tried to keep quiet while other Asian and Latin American bankers merrily devalued. Last week, it yelled a loud “enough”, effectively triggering a frightening free-for-all.
The Fed and Super Mario can’t really do much more, can they?
In fact, pressure will build on the Fed NOT to raise rates as the strong USD keeps hurting commodities and emerging markets.
(…) crossborder US dollar-denominated credit to non-banks has risen from $6T to $9T since 2008. Roughly $4.5T of that crossborder USD-denominated credit has been extended to firms in emerging markets, largely via international bond issuance. As a result, the rising US dollar is a margin call on increasingly burdened emerging market borrowers. (Evergreen Gavekal)
Not only burdened by the rising USD, but also by the continuing decline in commodity prices, making the servicing of such debt, never mind its eventual repayment, impossible. The reality is that the lenders are getting increasingly shaky, threatening to morph into huge black swans of diverse nationality since, back in 2010-1013, just about everybody with loose change wanted to get on the ever swelling Chinese bandwagon.
The damage has already begun in the energy complex…
The Federal Reserve, Office of the Comptroller of the Currency and Federal Deposit Insurance Corp. are telling banks that a large number of loans they have issued to these companies are substandard, said people familiar with the matter, as they issue preliminary results of a joint national examination of major loan portfolios.
The substandard designation indicates regulators doubt a borrower’s ability to repay or question the value of the assets that back a loan. The designation typically limits banks’ ability to extend additional credit to the borrowers. (…)
A number of energy companies already have filed for bankruptcy protection, and others are exploring options to raise capital or restructure their debt loads.
So far, the suffering hasn’t been as widespread as was initially feared when prices plummeted last year.
That’s because many rushed to issue equity early in 2015 and because hedges are still in effect at high prices, but not for much longer…
The suffering has also begun in mining…
…and in the high yield debt market…
…and the hedge fund universe…
…potentially eventually reaching banks caught in this currency-commodity collapse, exacerbated by the Fed’s next move.
One thing is certain: there will be blood!
Recall that the Fed’s mandate includes nothing related to foreigners. The Bundesbank said the same to Treasury Secretary James Baker on October 17, 1987. Baker was then imploring the Germans to let the Deutschmark weaken, even threatening to devalue the USD in order to narrow the U.S. widening trade deficit. After the Bundesbank politely told Baker to take a walk, investors lost confidence in central banks willingness to coordinate policies in order tackle global issues.
This is happening now. Draghi engineered the devaluation of the euro with the blessing of the Fed. What was good for Europe was good for the U.S. and the world. Then Abe did it with the Yen. What was good for Japan was good for the U.S. and the world… But it was not that good for China which had been silently watching the yuan appreciate since 2010 bringing its exports into negative growth in 2015.
Real Effective Exchange Rate and Export Growth
For much of the past 4 years, China’s manufacturing PMI has been in contraction territory but that was offset by its strong Services sector. This is not happening in 2015, forcing Beijing to become much more self-centered.
What is good for China may not be all that good for the U.S. and the rest of the world if it means deflation and a race to the bottom in this currency zero-sum game.
Exactly one month from now, the FOMC will decide whether to start raising rates or not. What is best for the U.S.? And how good will it be for the rest of the world?
Investors bought QE1, QE2 and QE3. They bought Draghi’s “whatever it takes”. They bought Abe’s arrows. These were all confidence boosters. Whatever was happening at the political levels, the central banks were there for financial markets. Confidence is so high now that volatility has almost disappeared from an inherently volatile market.
Since 2010, confidence was shaken three times, each time exploding the Vix and cratering the Rule of 20 multiple: –3.8 points in 2010 to 15.4, –2.4 points in 2011 to 16.3 and –1.8 points to 18.0 in mid-October 2014 when, after the S&P 500 Index dropped nearly 10% in 4 weeks, James Bullard restored confidence by hinting at QE4 if necessary (“We could react with more QE if we wanted to.”)
When the Rule of 20 fair index value is declining (yellow line on chart, reflecting trends in trailing earnings and inflation), equities have no sustained tailwind to keep advancing. Only higher P/Es can propel equity markets higher. With inflation as low as it is now and all central banks focused on boosting prices, confidence is crucial to transform excess liquidity into higher stock prices.
When we are left hoping that technical indicators will hold, it is time to walk away and leave our camel alone for a while.