As US company earnings rise and major stock market indices hit new heights, two small problems remain: revenues are static and the trajectory of earnings growth is slipping.
The tech-heavy Nasdaq closed Thursday at 5,056, its first close above its previous record high since March 2000, while the S&P 500 briefly topped its previous record high set last month only to close five points shy at almost 2,113. Both got a boost from ongoing reports on first-quarter earnings, which have risen despite facing headwinds from dollar strength and weakness in the energy sector.
Earnings are up at a 9.1% year-on-year clip among the 40% or so of S&P 500 companies to report through Thursday morning, according to data from Zacks, but with zero aggregate growth in revenues. More than two-thirds of those reporting beat expectations. All on zero revenue growth.
But how? After all, earnings have to come out of revenues, and though efficiencies can help, there is a limit.
The answer, of course, is buybacks. US companies have been on a binge, buying back US$553bn of their own shares last year and on course to beat that easily this year. Overall US earnings growth has been boosted by 2.3 percentage points by buybacks alone, according to data from Societe Generale.
Indeed, if you look at earnings as an accountant would, meaning under generally accepted accounting principles (GAAP), then US earnings are actually in decline, and are back to about where they were in 2010. Pro-forma earnings, the basis on which companies report, allows them to ‘look through’ writedowns and one-off items. So, financial engineering, and remember a lot of those buybacks are needed just to offset the shares handed out to executives, and ‘one-offs’ can give an unrealistic view of a company’s performance, not to mention its future prospects for growth.
“Discussing actual profits seems a little old school these days as for many investors QE appears to be the only game in town,” Andrew Lapthorne, a quantitative analyst at Societe Generale, wrote in a note to clients.
“As such the current QE-inspired rising markets provide a handy reason to ignore most other metrics, including weakness in underlying company fundamentals. But those still interested in such things might want to note that consensus earnings expectations have declined substantially in 2015.”
Fading momentum
While energy and the translation impact of a strong dollar have played a role, earnings momentum, the proportion of upgrades among estimate changes, in the US is declining. Over the past three months earnings expectations for the coming year have fallen by five percentage points. And it isn’t simply an energy story, though there is true carnage there. Consumer durables and apparel and consumer services expectations for the next year are all down more than 6% in the past month, according to Societe Generale.
The global earnings picture is not too dissimilar: falling momentum, even taking currency movements into account. For the global universe of companies, earnings expectations for 2015 are down 5.3% so far this year in currency-neutral terms, and down 3.5% even if you exclude energy and financial companies. With global earnings growth, excluding financials, for 2015 expected to be just 1%, if the momentum holds we will soon be looking at lower figures than those companies reported in 2014. Even trailing earnings for the global MSCI universe are down 5.5% over the last year.
So again, we return to the question of how, if earnings are looking fragile and revenues, at least in the US, are flat, stocks can continue to rise.
“As more and more non-weather-affected economic and corporate data comes through below expectations, the bullish consensus is going to need some new excuses,” Lapthorne writes.
Backstopping all of this involves a circular argument by investors.
Low rates make it cheap to issue debt to buy back shares and also, especially given QE in Japan and Europe, make equities more attractive to investors desperate for a bit of return in a yield-starved world. If the economy falters, the Fed will keep rates low and might even revisit QE, underpinning stocks, investors believe. If the economy actually recovers from its first-quarter pause, then away we go as corporate revenues rise at last. Even better, low corporate investment may help to keep margins unusually fat.
The middle way, stagnation in the economy and, soon, stagnation in earnings, might be a good bit less pleasant.
Unless of course the next round of QE involves buying goods and services directly from companies.
That’ll drive revenue growth.
(James Saft is a Reuters columnist. The opinions expressed are his own. At the time of publication he 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 jamessaft@jamessaft.com)
