Earnings and revenues can't diverge forever
Just about halfway through the US third-quarter corporate reporting season and we find that 59% of S&P 500 companies have beaten their earnings estimates, down a bit from last quarter but still an upbeat number. And yet about 60% have missed their sales targets, meaning that corporate America is somehow extracting more profit than promised despite bringing less money into the tills than expected.
That’s admirable, but perhaps a bit disturbingly close to magical.
On many readings, all is rosy in the land of equities. Not only does the market have crucial support from central banks bent on forcing money into risk assets (and hoping some of the profits get spent), earnings are at record highs and the amount investors will pay for a share of those earnings is going up.
Analysts are forecasting fourth-quarter earnings to grow at a near 9 % clip, down from the 17 % they were pencilling in earlier but still enough to take the earnings of the S&P 500 to almost US$27 per share, in what would be yet another record.
In some ways this is reminiscent of the housing market in the middle years of the last decade, where prices, year after year, outpaced wage and income gains.
And next year analysts are looking for growth of about 12%. That optimism, combined with quantitative easing fever and complacency over the euro zone, has allowed price-to-earnings multiples to expand, and not just in the United States.
On a global basis, forward-looking P/E valuations have gotten richer since early June, according to Morgan Stanley analysis, most notably for companies in mining, materials, energy and even finance.
That’s all well and good, but very hard to square with the increasing number of companies saying they haven’t been able to deliver promised growth in revenues. The huge majority of S&P 500 companies giving revenue or earnings guidance for the coming quarter have guided downwards, according to data from FactSet.
Third-quarter revenue for chemicals company DuPont DD.N dropped 9.2 % from the year-before quarter, to US$7.4bn, below the US$8.15bn analysts expected, a miss the company blamed on global drops in demand. DuPont slashed its full-year earnings estimate to between US$3.25 and US$3.50 a share from about US$4.20 before.
Similarly, farm and construction equipment maker Caterpillar Inc CAT.N lowered its forecasts for the second time in a year, citing economic weakness and uncertainty.
Where’s the growth?
So, we have a trend towards lower revenue growth, a dwindling number of companies beating expectations and yet a world in which investors see this combination as growing in value.
In some ways this is reminiscent of the housing market in the middle years of the last decade, where prices, year after year, outpaced wage and income gains. The argument then was that incomes would soon catch up and that housing was cheap on a financing basis.
Housing, of course, was brought down with a thump when people finally worked out that the two numbers - cost and the amount of money available to service the debt backing that cost – could not forever drift further apart.
So it may prove for shares.
Surely some of the growth of earnings is a credit to company managers, who are proving unrelenting in wringing efficiencies from corporate structures, allowing for earnings growth even in challenging times.
Earnings are, on some level, an opinion. There is art to it as well as just math. Think about a bank which values assets and that drives earnings: those marks are ultimately subjective. While earnings may be more or less than meets the eye, a dollar in revenues is always a dollar.
Try this: compare earnings on an economy-wide basis and compare to overall economic output. On this measure, corporate America does not have a lot of room to expand its share of the pie, because earnings as a percentage of GDP are at near-record highs and are about half as high again as the kinds of figures we saw in most of the past 50 years.
The upside is, if the growth of earnings is confirmed over time by growth in the economy, this would send money flooding into corporations and allow for equity prices to rise even more relative to earnings. That, of course, depends on the fiscal cliff, the euro zone, China and any number of other tough-to-call macro issues.
The downside, of course, is that earnings revert to mean in terms of their share of overall output. When you track U.S. wages against profits, you see where most of the expanding share is coming from.
It may well be, especially if the government is not going to become much more leveraged, that profits will be limited by wage growth within a context of low overall growth. That particular scenario is only an outside chance, but one which would cause a big fall in shares.
Ultimately, the pie is going to have to grow for equities to hold their ground, much less gain more.
(At the time of publication James Saft did not own any direct investments in securities mentioned in this article. He may be an owner indirectly as an investor in a fund. You can email him at email@example.com)