Earnings Deceleration and Equity Prices

If you believe, as my pal Larry Kudlow does, that profits are the mother’s milk of stock returns, then you should be concerned with the following analysis:

Corporate profit growth is decelerating — and at significantly quickening pace.
So, too, are earnings expectations for the coming year. As noted earlier this week, the S&P500 double digit year over year profit streak has ended.

The big question then, is, what might this mean for equities? In the Sunday NYT, Paul Lim looks at what this might mean:

"After increasing at a double-digit rate for several years, earnings for companies in the S.& P. 500-stock index are expected to grow by only 3.3 percent in the first quarter of 2007, according to Thomson Financial. This represents a huge drop in expectations, as Wall Street analysts at the start of this year were expecting a first-quarter growth rate of 8.7 percent.

The second quarter doesn’t look much stronger: analysts are predicting profit growth of just 3.5 percent.

And after soaring 16 percent last year, corporate earnings for the full year are expected to increase by only 6.3 percent. “Analysts have pretty much cut their forecasts in half for the year,” says Jack A. Ablin, chief investment officer at Harris Private Bank in Chicago."

Historically,  earnings growth runs about 7% — roughly the combination of inflation and GDP.

Mean reversion, however, does not simply return a measure to its historical average. Rather, it oscillates above and below. While 6.3% is a respectable number for earnings growth, it is important to note that the profit growth is a cyclical phenomena, swinging wildly above (+28% a few years ago) and wildly below (minus 25% a few years before that).   

The S&P’s Sam Stovall looked at prior eras of earnings growth deceleration from 1966 to 2000. The Times notes that "in 4 of the last 10 such periods, the S.& P. 500 lost value. But this means that in a majority of cases, stock prices still managed to climb in the face of slowing profits. In fact, the average gain for the S.& P. 500 during these slowing periods was a respectable 7 percent."

That 34 year period niucely encompasses two major secular periods — a major Bear market (1966-82) and a major Bull market (1982-2000). I would be quite curious to see how the breakdowns of positive and negative returns relative to earnings growth correlated to these different periods. (We are presently in a secular Bear market, running from 2000- 20??).

As the article further notes, its "not just the rate of earnings growth, but also
the underlying trends." We would much rather buy low earnings growth — but when its on the upswing — versus medium earnings growth on the downswing.

Back to the NYT:

"Periods when the earnings growth is high but falling tend to be challenging for the market, [Tim Hayes, chief investment strategist at Ned Davis Research] said. It’s during these periods, he said, that “the market begins to question the sustainability of earnings growth.” And “the market becomes vulnerable to disappointments,” he added.

Despite the swoon in stock prices in late February, the markets haven’t come close to pricing in the coming earnings slowdown, in the view of Richard Bernstein, chief investment strategist at Merrill Lynch.

“What’s happening now is an odd situation where earnings growth looks like it’s slowing, but people are hesitant to make that bet because every time they’ve made that bet in the recent past, earnings have surprised to the upside,” Mr. Bernstein said.

For the last 15 of the last 16 quarters, analysts’ estimates for earnings growth have turned out to be too pessimistic. And Mr. Thompson added that analysts have recently underestimated actual earnings by around 3 percent.

“It’s now almost become a Pavlovian response,” Mr. Bernstein said, where investors immediately bet on better-than-expected earnings once analysts post their forecasts."

Since we mentioned the recency effect yesterday, consider this: in terms of profit growth, both the most recnet data point AND the overall trend are pointing in the same direction: downwards.



Graphic courtesy of NYT


A Caution Signal on Profits. A Red Light for Stocks?
NYTimes, April 8, 2007

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What's been said:

Discussions found on the web:
  1. Frankie commented on Apr 8

    “(We are presently in a secular Bear market, running from 2000- 20??).”

    That’s you’re opinion Barry. This premise is your starting point, and consequently skews your view of the glass (and is not surpising to readers of TBP.)

    Oh, and I thought I read Bernstein recently RAISING his expectation for the S&P this year to ~12% by year end?? Kindly share the whole picture in this regard.


    BR: Frankie — you will note that I fastidiously cite and link every resource, quote and attribution I make. If you are going to quote someone like Merrill Lynch’s Richard Bernstein, please include a link or at least some citation.

    As to the Secular issue, have a look at this 100 Year Dow Jones Industrials Chart, and then get back to me . . .

  2. Grodge commented on Apr 8

    In the graph at the end of the post, what are the light and dark bars representing?

  3. Philippe commented on Apr 8

    The leading indicators as of April OECD are still not portraying very much upside for the global economy for the next six months except China, which is resilient.
    There is a scissor effect, which comes from slowly raising to steady interest rates and declining GDP.
    It will require more and more skill to extract profits from a global declining growth.
    MSDW analyst’s projections bottom up stand at 3.8 PCT for this quarter (Global economic forum)

  4. wally commented on Apr 8

    “That’s you’re opinion Barry.”

    Well, duh.

    Of course it is his opinion. Whose opinion is he supposed to post? If you don’t want to read his opinion, don’t come to his blog.

  5. wcw commented on Apr 8

    I updated the “golden age of profits” chart of corporate profits as a share of national income back to 1929, and linked, so it should show up as a trackback above. You may see the graphic directly here (PNG). Corporate profits are at historic highs. While it’s certainly possible that they’ll continue to take a growing share of national income, they’re currently at 13.8%. Only in one quarter since 1929 have they exceeded 14.1%.

    My expectation is that profit share will fluctuate around current levels, so earnings should indeed grow at “roughly the combination of inflation and GDP.” If anything, the risk to earnings growth is downwards, should employee compensation ever take a bite again, but given the verities of globalization I don’t expect that any time soon.

    There is nothing wrong with earnings growing at GDP + CPI. US equities are fairly priced, or even cheap if you compare their payout in terms of dividends plus buybacks to treasury yields. I’m mostly long gamma right now in both equities and bonds, but despite my continued worries about GDP this year, I can’t see not being net long stocks until something turns in the data.

    You can always hold some synthetic puts against your portfolio, or a synthetic straddle like I do. Calls are @#%! cheap. Sure, volatility (aside from the late-February drawdown) is even lower, but the insurance is very inexpensive right now.

  6. m3 commented on Apr 8

    Historically, earnings growth runs about 7% — roughly the combination of inflation and GDP.

    hmm… but if m3 (i.e. inflation) is expanding at over 10%, wouldn’t a 7% increase in nominal growth actually be a 3% decline in real growth?

    it’s especially troubling since most of the growth in the past couple years has come from energy, which *benefits* from high inflation rates.

    it’d be interesting to see a chart of how the real growth rate has changed, adjusted with m3, rather than the CPI.

  7. alexd commented on Apr 8

    How might make money off it? I am always concerned with application. I pesume a large macro bet might be affected by this but playing it off smaller postions is ? But if a agreee or disagreee with the idea that profits overall might be seen as decreasing from here, how do I best utilize the information? Let’s presume I desire the highest returns with the least amount of risk in a given period of time.

    I suspect with so many influences upon the sectors of the world economy that this macro idea is going to influence our investments in different ways. For example I am personly inclined to think the dollar is in a long term downtrend. Hence I am more inclined to want to bet on something that has the affect of that decline acting as wind in my sails. But if I found an investment that was increasing the value of my capital sufficently in a given period of time, I might ignore that aspect.

    The most interesting aspect to me is not whether overall profits are going down but rather if it is true then when or what should I look for as a turning point?

    So do I go short Target and go long Alon, and the other refiners?

    Hope this initiates more conversation.

  8. wcw commented on Apr 8

    M3 <> inflation, because velocity of money is not a constant.

    Here, let Ben Bernanke tell the story:

    Unfortunately, forecast errors for money growth are often significant, and the empirical relationship between money growth and variables such as inflation and nominal output growth has continued to be unstable at times. 18



    A recent example of instability occurred in the fourth quarter of 2003, when M2 shrank at the most rapid rate since the beginning of modern data collection in 1959 without any evident effects on prices or nominal spending. Subsequent analysis has explained part of the decline in M2 (the transfer of liquid funds into a recovering stock market was one possible cause), and data revisions have eliminated an additional portion of the decline, but much of the drop remains unexplained even well after the fact.

  9. super-anon commented on Apr 8

    Barry, if we can get a nice stock market bubble going with lots margin debt and get Joe Six Pack back off the sidelines and into equities (a guy I work with just invested several hundred thousand dollars in equities for the first time in his life even though he couldn’t answer the question “how do you determine the value of a stock?”), then profits simply don’t matter.

    Let’s bring back the good old days.

  10. theroxylandr commented on Apr 8

    >>> “(We are presently in a secular Bear market, running from 2000- 20??).”

    >>> That’s you’re opinion Barry

    That’s my opinion too. We are far, far below levels of 2000 and we just can’t make it in face of slowing profits.

    It’s a lower high that we just saw, and then I guess we’ll see lower low

  11. johntron commented on Apr 8

    As a tangent to the slowing economic growth thesis…as interesting anecdotal indicator is the starting salary for “Big Law” associates, which currently rose to $160k in NYC.

    I’m a former attorney and roughly the top 80 law firms “Big Law” operate like a monopsy, generally paying the same lock-step wage scale. When wage pressures finally trigger a hike in the starting salary, the past pay hikes have coincided nicely with the peaking of the economic cycle.

    1990 rose to $70k
    1991 – 1999 stayed at $70k
    summer 1999 – spring 2000 jumped to $83k, $90k and settled at $125k
    2001 – 2006 stayed at $125k
    Winter 2007 jumped to $160k

  12. Frankie commented on Apr 8

    That “secular bear market” chart is data mining at its finest, imo. There are multiple examples where I could “color” it differently, with longer or shorter trends.
    The bear market ended in March ’03.

    I could’nt find the Rich Bernstein link I (thought) I heard. I apologise if I’m mistaken on that front.

    PS…what happens if/when we make new highs in a few months?

  13. Barry Ritholtz commented on Apr 8

    Make another chart and color it the way you believe it should be.

    Then post it online — be sure to leave it open for comments.


    As I have stated in the past, the damage was in the Nasdaq, whoch dropped 78% (amazingly close to the 1929 Dow drop). The Nasdaq is STILL OFF more than 50% from its peak.

    The Dow and SPX barely suffered comparably. Thats why I am not surprised by the new highs in the Russell 2000, the Dow Trannies, the Utilities or the DJIA.

  14. Estragon commented on Apr 8

    Frankie – a new high on the long cycle chart BR posted would hardly qualify as a screen artifact. It would have to be substantial and sustained in order to invalidate BR’s long wave secular bear thesis.

  15. Fred commented on Apr 9

    Well you guys (bear market believers) might want to ask yourselves one question — do you think Warren Buffet would be buying railroads if he felt we were in a bear market, or a toxic economy?

    Color me curious!

  16. Estragon commented on Apr 9

    Fred – IMV, Warren Buffett is an excellent bottom-up stock picker. He has a talent for finding companies with long-term competitive advantage and sustainable and growing cashflows. I believe he characterizes his holding period as “forever” though, which is somewhat longer than my own. On that basis, I wouldn’t infer a macro timing call worth trading on from his buying a railroad. I doubt Buffett himself would either.

  17. angryinch commented on Apr 9

    Enough already with the “Buffett=Genius” meme.

    When Buffett bought a big stake in the retailer PIR back in 2004, was that a sign that retail was about to experience a huge renaissance? Nope, PIR dumped 72% shortly thereafter.

    And if he was such a savant, how come he forgot to sell any of his biggest position, KO, which has been making lower lows since peaking back in 1998 and is still currently trading at 1996 levels?

    Not to mention, Berkshire Hathaway (BRK.A) made zero net gain in the eight years b/w June 1998 and July 2006. Dividends didn’t soothe the pain since BRK.A doesn’t do dividends.

    Buffett has made some good decisions, some bad ones and some middling ones. Overall, he has made a lot of money, as has anyone who has bought SPY or another tracking fund for the past 25 years.

    Most of Buffett’s “genius” reputation was based on his record from quite a while back. BRK.A badly underperformed the SPX from 1998-2000. And he has slightly underperformed the SPX since the 2002 lows (82% gain for BRK.A vs 90% for SPX) and even worse when you factor dividends.

    His fund held up better than the SPX during the 2000-2002 selloff (-25% vs -50%) but that’s largely because BRK.A had already dumped -50% from 1998-2000 at a time when the SPX gained 31%.

    Buffett has done very well, as have his shareholders, over the broad scope of time. But the last 10 years or so, there’s nothing noteworthy about his performance.

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