The Rising Risk to Earnings

Part III of Cult of the Bear will be out later this morning — talk about fortuitous timing! — and I’ll be on CNBC Morning Call, going over the charts from Cult of the Bear part II at 10:45 today.

The hardest part about tying together the top down, macoeconomics discussion (from Part I) and the cyclical/technical analysis (from part II) was getting it down to a reasonable length. I tried to explain how I derived the 30% haircut and Dow 6,800, but its not easy explaining the entire process in a mere 1,500 words.

I had to cut the following from Cult of the Bear, part III, ot keep it under 1,500 words — but this is a worthwhile discussion, and so I include it here for your reading pleasure:

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Risk to Earnings

It won’t take a housing “crash” to dramatically impact the economy. As the numbers eventually fall back towards the historical mean, cash out refis will slow, and the long-awaited consumer spending slowdown will appear in earnest.

The first to feel the pinch will be the firms that have most benefited from the refi boom: Contractors, the Home Depot and Loews. They should expect to see the home addition and remodeling business slow dramatically.

Given the heavily promotional holiday price cuts, I expect that many retailers – Wal-Mart, Target on the low end, Tiffany and Nordstroms on the high end — will see the margin pressure impact earnings. And here’s where things start to get ugly.

Most retailers are priced for growth, not contraction. With profits squeezed, a consumer slowdown suddenly would make these companies look very expensive in a hurry. As Christmas 2005 showed us, American consumers have become surprisingly price sensitive and increasingly reluctant to spend. 

In a non-stimulus driven environment, real (after inflation) wages rise, and consumer spending along with it. Instead of real wage growth, there’s been a lot of consumer borrowing propelling their spending. As that borrowing slows, so too will consumer spending.

Managing Earnings

As strong as earnings have been over the past 14 quarters, even that has some hair on it. A disproportionate percentage of S&P 500 earnings gains — by some measures, as much as half — have come from the energy sector.  High energy prices eventually suck all the oxygen out of the room, as we saw with Alcoa’s and DuPont’s earnings and 2006 guidance.

But it’s not just energy. Consider the massive share buyback programs. In 2005, nearly half a trillion dollars worth of shares were repurchased. This has had a huge impact on earnings per share.

How big? Stock repurchases are responsible for about one third of per share earnings gains.

In the third quarter, S&P 500 earnings were up 11.5% on a per share basis. But a study by Merrill Lynch’s David Rosenberg reveals that operating earnings in dollar terms were up only 7.8% on a year-over-year.  That’s the narrowest gain in dollar terms in three years.

Share repurchasing is masking a significant profit deceleration. That’s earnings management at its finest.

Expensing Options

Slowing growth and crimped consumer spending isn’t the only risks to equities:  options expensing comes into the fold this year. Companies on calendar years are required to expense options, starting this quarter. The effects of expensing options will be seen in first-quarter guidance and full year.

Firms have had over a year to get a handle on this, and yet there are signs that many may not be fully prepared. A recent Wall Street Journal article noted that since Microsoft

voluntarily started expensing options last June, its stock has hardly budged, while the market sprinted higher from the 1H 2005 lows. If mighty Microsoft could not gain traction during the rally to 5 year highs because of options expensing, imagine the impact it could have on other, lesser companies’ earnings.

Structural Imbalances Create Vulnerability

Past emergency situations such as the Asian currency crisis and the
Long-Term Capital Management meltdown were able to be managed because
of economic strength. When they occurred, markets were in the midst of
a bull run and the economy was organically growing. The Fed had lots of
room to add liquidity to the system. The economy shuddered a bit, but
handled these shocks well.

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Potential Negative Catalysts

Avian Flu Pandemic
Major US corporation enters bankruptcy
Israel-Iran war
Rising protectionism in US and Europe
US Dollar Crisis
Inflation becomes increasingly robust
Domestic Political scandals and trials
US fiscal deficit worsens
The Fed Overtightens
Energy Shock
US current account deficit approaches $1T deficit
ECB and BOJ tighten monetary policy
China allows major currency appreciation
Geo-strategic risks increase

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Today, the economy has far greater structural imbalances. As the markets get further extended, they become increasingly less able to absorb what has become euphemistically described as “an externality.”  As the current account deficit rises and the U.S. fiscal deficit worsens, so too does our ability to shake off an economic disturbance. Nouriel Roubini, Professor of Economics at New York University’s Stern School of Business, calls this an “increased probability of a systemic risk episode.”

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The full column (minus the above) should be out around 8am this morning . . .