Downunder Daily : How Deep Is the Valley?
Yes,
the main game now is judging the time and strength of recovery... but remember just how high earnings remain. While
investors may be able to look over the valley to the ultimate recovery, it's
not clear that they appreciate how deep that valley may be.
The resilience in earnings is a non-financial
phenomenon. Exhibit 1 shows US earnings split between financials and
non-financials (both rolling four-quarter totals as a share of GDP). As I've
noted before, the peak in earnings for the non-financial sector was the
September quarter last year - the earnings decline (for non-financials) is just
two quarters old. Earnings remain well above the long-term average. So do
margins. Exhibit 2, from our US strategy team, is a bottom-up aggregation of
EBITDA margins. (March quarter data are based on a 95% sample.)
How can earnings appear to be so high in the
face of ostensibly terrible earnings news, including the first-ever aggregate
loss for the companies listed in the S&P 500 index in the December quarter?
Several factors are at play:
First - obviously - is that the losses have
been heaviest in the financials. As Exhibit 1 shows, financial-sector earnings
are now below the long-term average.
Second, it depends on the measure of
earnings. The December quarter loss was on a GAAP basis. All other measures of
earnings have been stronger (less weak). Exhibit 3 compares the change in
four-quarter GAAP earnings and the IBES earnings series (which is an 'earnings
before bad stuff' series).
Third, EPS have fallen further than aggregate
earnings have due to equity raising.
Finally, savage cost cutting has (partly)
protected margins. In the March quarter reporting season, earnings beat
expectations while revenues fell short.
The forward-looking point is that cycle
pressures seem set to squeeze pricing power and margins, and operating earnings
will fall further. In this sense, this remains a normal cycle: Operational
leverage and excess capacity will reduce earnings.
There is now excess capacity wherever you
look. Exhibit 4 shows spare capacity in US manufacturing, and 'excess capacity'
in labour (the unemployment rate). Both are at multi-year highs, and our US
economics team expects both series to deteriorate further.
Exhibit 5 shows how excess capacity squeezes
margins in manufacturing. The proxy for margins is selling price (PPI) less
unit labour costs. As excess capacity rises, the gap between selling prices and
labour costs falls.
The question now is not whether earnings will
fall, but how much of a decline is in the price. It may be that the sell-side
consensus 'over-cut' their earning forecasts through the period of economic
free-fall earlier this year. The usually tight correlation between earnings
revisions and cycle indicators, such as the ISM, broke down earlier this year,
with earnings revisions being exceptionally severe (Exhibit 6). However, as
markets go higher, they are either implicitly upgrading those earnings
forecasts, or looking for a rapid rebound in earnings from the near-term lows.
My biggest problem with earnings forecast is
the pace of the rebound. While analysts (and investors) realize that this will
be a bad year for earnings, the explicit assumption of forecasters -
increasingly implied by market pricing - is that earnings will rebound aggressively
through the cycle recovery. My view is that the structural underpinnings of the
earnings bubble have crumbled, and while earnings will recover, they're
unlikely to rebound as far as expected.
Thanks to Dipojjal Saha for helping with this
report.
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END OF RESEARCH ABSTRACT
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