How Long Will the Bears Let Goldilocks Sleep?

How Long Will the Bears Let Goldilocks Sleep?

Corporate earnings estimates have been lowered for 13 straight quarters

  • Corporate profits using GAAP are now only back to the level of earnings prior to the 2008 financial crisis
  • Earnings “massages” are back in vogue,  gimmicky accounting tactics not seen since the Great Recession.
  • Stock prices have recently been driven by corporate actions and low interest rates as opposed to the more typical earnings/stock price relationship.

We all know share prices follow earnings, right?  Here is how it is supposed to work:  companies do a good job of creating products that people want, while controlling costs and protecting against competitive pressures. Then, companies earn reasonable profit margins, and steadily grow their customer base. Their earnings grow from demand for their products, the earnings from which drive more investors to buy their stock, as a result the company’s stock price moves higher.

“The stock market should make sense, and could make sense, but nobody ever said the stock market had to make sense.”  – David Rosenberg, commenting on recent market behavior

I tend to agree with Mr. Rosenberg—it’s difficult to make much sense of current markets given that a great many fundamental economic relationships are being stretched, partially due to the Fed’s unconventional monetary experiment.  For example, stock prices generally should follow the path of earnings. Yet, the stock market keeps charging ahead, even though earnings have stagnated with the broader global economy.   Sure, there are companies that have done a good job of continuing to grow their earnings, but those companies tend to trade with expensive multiples in response to their stellar growth in a tough economy.  To understand the broader market as a whole we have to step back and look at the collective earnings prospects of the 500 largest companies in the U.S., otherwise known as the S&P 500.

The stagnation of the U.S. economy that we evaluated in last month’s blog is visible in the charts of corporate revenues and earnings pictured above. Just as economists have had to adjust to economic reality by sharply lowering their growth expectations, so too have analysts who follow corporate earnings. These confirming signals reflect how various analytical perspectives on Wall Street have been slow to see the recent reality of stagnant economic growth since the financial crisis.  Ultimately, corporate earnings are beholden to the broader economy. In response to tepid demand, companies have squeezed costs and sought to benefit from lower interest rates in the short run. In the long run, companies need a growing economy to feed growing earnings.


This graph above focuses on how actual earnings have compared with expected earnings.  Typically, we see stocks sell off when their earnings disappoint analysts’ expectations, but we have not seen that normal, self-correcting market behavior during this period.  Note that analysts have had to cut their earnings expectations in half in each of the last five years. And this year, once again, analysts are expecting double-digit earnings growth for the next two years. Every year for the last five, investors have started the year expecting earnings growth in the 10-15% range, and have had to cut them to below 5% and to near-zero growth in each of the last two years. Meanwhile, stocks have been setting new all-time highs throughout this period, undeterred by the reality of faltering growth and the perils of great expectations.  Investors are approaching the stock market with a good news is good for stocks, and bad news, which brings lower interest rates, is good for them too, mentality.


Instead of evaluating earnings on their merit, companies are offering an alternate view of their financial statements, via pro-forma earnings releases. Pro-forma earnings, which do not adhere to the Generally Accepted Accounting Principles (GAAP) put forth by the Financial Accounting Standards Board (FASB), often are an effort to paint a portrait of earnings in the best possible light.  Many companies prefer pro-forma earnings because they can sweep away mistakes and focus on the good parts of the operation.  Pro-forma earnings often allow for write offs, exclude stock-based compensation, and add back non-recurring items, which tend to smooth and inflate earnings. Needless to say, Warren Buffet is not a fan of pro-forma earnings statements, and neither am I. Nevertheless, we can broadly understand the quality of earnings by the gap between pro-forma, or management’s spin on earnings, and their GAAP earnings, which are used for compliance with financial statement regulation.

In the chart above, the blue bars represent the more conservative GAAP approach to company earnings, while the red bars are companies’ view of earnings through rose-colored glasses. We tend to see the bars deviate during times of stress, as companies stretch to make their numbers appear stronger.  Notice the last time we saw a discrepancy this wide was back in 2008 when companies were pulling every accounting trick in the book to appear strong and solvent.  At present, approximately 25% of reported earnings are “debatable” in quality.  Also, notice that the overall level of earnings rebounded from the Great Recession, yet seven years later, we have only reached the same level of earnings as the peak of the last business cycle in 2007. That means very little true earnings growth has been realized during this business cycle.


Investors are finding a way to get comfortable and feel “juuuuust right!” in every room of the bear’s house, ignoring all of the obvious signs of danger.  We see in the above chart by BMO that S&P earnings (orange line) have clearly been rolling over from approximately 14% earnings growth in 2012 to -3% within the last year.  The steady erosion in earnings has brought disappointments in each of the past 4 years.

At the same time, the blue line in the chart above shows the P/E ratio, or the premium paid for current and expected earnings, has steadily grown from 14 times trailing earnings to over 19 times.  As of the time of this writing, the P/E ratio is currently over 21 times trailing 12 month earnings. That essentially means that investors have upped their bet from paying $14 for a dollar of earnings, to now paying $21 for the same bet. When investor optimism outpaces earnings growth, stocks become increasingly expensive.

The optimistic argument du jour has shifted to “We can no longer ignore the fact that earnings growth is declining into negative territory, but by golly, that means that earnings are hitting rock bottom, which means they’re just about to rise again!”  Of course, this tune of optimism is starting to sound a bit like “the Boy That Cried Wolf”, in that repeated cries for something that does not materialize eventually leads to doubt and loss of credibility… high hopes for next year’s earnings have not materialized for four straight years.

In this issue we analyzed the level and quality of earnings, following last month’s blog on the broader economy, which looked at how optimistic forecasters have been continually disappointed by the realities of a stagnant economy. This analysis of earnings and earnings expectations shows the same pattern—earnings expectations continuously come out overly optimistic, only to be downgraded to easily beatable numbers. What’s clear is that earnings are not growing, yet stock prices are rising, and companies are putting the best possible spin on their stagnation to support their stock prices and executive compensation. If it’s not earnings, then what is driving stocks to new all-time highs? Is this just a Fairytale?  Will it be a Disney or Brothers Grimm ending?

Next month, we will dig into the corporate behavior that is disctracting the Bears in the forest for now and keeping them from returning home to crash the party.  To better understand what is helping to levitate the stock market, we will expand on share buybacks, mergers and acquisitons, and the impact of these transactions on equity prices.  In the meantime, I hope you are enjoying this Goldilocks rally.

Here’s to being more right than wrong….

CUTTING THROUGH THE NOISE – A Financial Blog by Will Martin, CFA

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