Carl Icahn just published a great video “The Danger Ahead” in which he outlines the major issues facing the US economy, US corporate earnings and the unwelcome side effects of the FED’s prolonged zero interest rate policy regime (ZIRP). In the video, with very easy to understand charts and graphs, Carl Icahn makes the case that ZIRP has elevated valuation levels of stocks and their underlying corporate earnings to unhealthy and more importantly unsustainable levels. We have been writing about that theme for years now and we think that Carl Icahn is doing a great service to investors and to US citizens overall by highlighting and explaining these issues. Mistakes in monetary policy inevitably lead to bubbles and consequently recessions in which real people lose their jobs and we can’t afford as a society for the FED to be continuously making mistakes. While we attend Global Citizen concerts which put front and center the issue of “Sustainability” (sustainable planet, sustainable economy, etc), it is very ironic that the most important economic institution in the United States – the Federal Reserve – is pursuing a monetary policy that promotes economic and corporate activity that is extremely short-sighted and is anything but sustainable in the long run. Maybe Janet Yellen should show up next time to the Global Citizen concert and learn about sustainability. At the very least she will enjoy some good music along with Michele Obama and Joe Biden.
As I mentioned in my March article Beware of the Imminent Decline covering our expectations for 2015 Q1 earnings, US corporations (S&P 500) have continued to deliver well below expectations. Lost in the daily CNBC coverage highlighting Nike (NKE) or some other winning company blowout earnings in the US and China, it is very easy to lose track of the big picture. And the big picture is not as fantastic as Nike’s earnings. For every Nike, there are 5 Glencores (GLEN) that are on the verge of bankruptcy. For every Apple, there are 5 Blackberries struggling to make ends meet. The irony is that while Nike employs about 50,000 people world-wide, Glencore employs 150,000. A company’s profitability and success is not necessarily equivalent to its real-world impact on the economy. Some of the most important companies from economic standpoint that employ hundreds of thousands of employees are in the mining, construction and manufacturing industries. Industries which are currently under duress. Industries that require metal, machinery, hard physical work, blue collar employees and real-world management. Those industries require a lot of investment, a lot of high-yield debt to finance construction and if things don’t work out, tens of thousands lose their job and tens of millions of investor money is lost. Not every company can be Facebook (FB), operate $500 million dollar data center in Oregon run by a bunch of guys who have never gotten out of a chair and print money from state-of-the-art targeted advertising to a billion users at a 90% margin. Not every company can be Google (GOOG) or Amazon (AMZN) and benefit from the network effect widely present in virtual commerce. Most companies deal with the real world and the real world involves physical locations and moving a lot of people and machinery and product at a low margin with the constant threat of capable competition.
So while I sincerely wish that the big picture is good, the world is what it is, not what I want it to be. And as investors we have to stay with our feet planted firmly on the ground and be realistic. A lot of the earnings analysis out there deals primarily with breaking earnings down by sector and figuring out where money is being made or lost. I prefer to stick to a macro approach and try not confuse my thinking with potentially unimportant details. A rising tide lifts all boats, a falling tide grounds all boats. Like the great Yogi Berra said “You can observe a lot by just watching”. At least a couple of times a year, we need to climb on top of the hill and observe the situation from above.
Review of Q1 and Q2 Earnings
Now that Q1 and Q2 earnings this year have been completely reported, let’s take a look at the situation:
The 1st and 2nd Quarters of this year were a relative disaster from an earnings stand point. GAAP EPS for Q1 came in 40% below original estimates (also called Forward Earnings Expectations). For Q2, the miss was a slightly better 38% (I hope that makes you feel better)! On a Trailing 12 Month basis, Q1 was relatively down 22% and Q2 came in with a terrible 30% miss. Just to illustrate what that means, the average miss from forward expectations on a T12M basis is about 18%. So both in Q1 and Q2 earnings disappointed quite a bit above the usual disappointment level. The great falling earnings expectations are best seen on a chart for which the data is getting retrieved consistently on a weekly basis:
Earnings Data Source: S&P 500
On a sequential basis, earnings in Q1 only declined 1.52%, not too worrisome, but Q2 served a whopper at 8.17% miss. An 8% miss for trailing 12 month earnings (1 year period) is a big reason to start questioning the P/E multiple because if the price stays where it is the SPY is starting to get real expensive, dividend yield starts to become miniscule and Brazilian government bonds start to look real good with a 16% yield, devaluation of the Real and Dilma Rouseff be damned.
Earnings Data Source: S&P 500
So it is not a surprise that the market has struggled of late. In fact the 12% correction so far has been right in line with the steady earnings decline present throughout this year. And I have this unfortunate news for the uber-bulls – unless the earnings picture improves going forward it will be very hard for the market to reclaim its all-time high of 2131 from May 21st. There is one positive during this rather sharp decline is that the P/E ratio has finally let up a bit, we are no longer at the nosebleed level of 22. We are back down to 20, which historically is still pretty expensive. The high end of what is considered “fair-value” historically is the 16-18 P/E range with 18x levels usually achieved during period of Central Bank accommodation. Unfortunately a 16x P/E valuation given that the earnings are now only $94 would mean that the SPX has to trade down to the 1520 level, a full on bear market and a disaster for the 401(k) of most investors.
S&P 500 Index closing prices: Yahoo
Preview of Q3 Earnings
Unfortunately, Q3 does not bring much of a respite. Q3 earnings are expected to be at $26.46, which is a 16% gain over Q2 which I think is highly unlikely to happen. Even at this level, this is still a dramatic decline from original March 2014 expectations of $37.2. On a T12M basis, earnings are expected to come in at 93.9 down from $142– a 34% miss already. But even more worrisome is the decline from 2014 – down 11.38% from Q3 of 2014.
So if you are looking for a sharp rebound in the market, it has to come at the expense of higher valuation. I think new highs are highly unlikely at this point until earnings for the index as a whole start to move upwards and show growth. At present we are dealing with year on year declines and I see nothing that will change that in the next few months.
It is important to understand that corporate earnings will continue to face pressure into 2016. S&P 500 corporate operating margins are down 7% on a year over year basis. The margin compression is driven by a few factors which will not cease to exist any time soon:
- Rising wages because of low unemployment levels
- Stretched consumer.
While the US economy now employs more people than ever at 149+ million and the overall consumer stats look good, on a per consumer basis, the economy is struggling with a “rent crisis”. In a lot of locations, people pay 50% of their income for rent and housing, an all-time high level. They have to pay back credit card debt because it is really hard to get a loan these days. Luckily, the vibrant private economy employs more and more people making the government statistics look good, but if there is the sense that the economy is not working for people it is because their personal finances are stretched and the great happiness elixir of cheap and easy credit is here no more (I mean who doesn’t feel good about spending money they haven’t earned yet?). As a result, consumers are feeling kind of unhappy, are really price conscious, they reject higher prices and only buy deals – hence our low consumer price inflation. When faced with low prices how do companies protect their profits? By producing more output which they sell at lower prices with more automation and fewer workers. So the economy will keep humming while everybody is unhappy. Welcome to 2015!
On the strong dollar, earnings have been partially helped by a relative stagnation in the dollar growth this year, which is a temporary development. ECB and BOJ have taken a break from their QE programs, but they will resume them soon enough as economic growth in Japan and Europe needs cheaper currency and more monetary accommodation. In addition, the upcoming inclusion of the Yuan in the SDR basket in March or later and subsequent at least 50% devaluation of the yuan will be a major trigger for strengthening of the dollar. At this point the dollar is not in the hands of the FED, but in the hands of Mario Draghi and Haruhiko Kuroda and Tian Guoli (Bank of China Chairman), regardless of whether the FED implements rates hikes or not. Currency movements at present are all about relative size of central bank balance sheets and the appetite in the US for expanding the balance sheet is pretty much over for the foreseeable future. In another article I published in March King Dollar Is Here To Stay, I calculated that the fair value of the US dollar index is 124. So some time over the next year or so, the US dollar will have another rapid 3-month ramp from 95 to the 115-120 level, which will add another punch to the decline in earnings. The US dollar is in a massive bull flag and bull flag always get followed by another bull flag. So both technically and fundamentally another big move up is coming eventually.
Stay flexible, the V-shaped recoveries are a thing of the past. New all-time highs will be very hard to come by. The US stock market is a facing a lot of headwinds and it will take time for those headwinds to play out. Unfortunately, this may even bring about a bear market over the course of 2016. While I think this current correction is near its capitulation point, we could very well be in for a long path down a la 2007 with many 50% retraces and then resumptions of the downtrend. You never want to be looking up at the 200 day moving average and have another 5-10% to go to reach it. The one thing I am optimistic about is that we will not have a Lehman like disaster – junk bonds are not as widespread systemic risk as mortgage asset backed securities were, energy is only 6% of the US economy vs 35% for banking and finance. In addition, US banks hold north of $600 billion in cash and are ready to withstand a collapse of an institution the size of Lehman or 3 Greek economies. So while we may have a few notable bankruptcies, I don’t see any too-big-to-fail events on the horizon and I don’t see a credit crisis. While GAAP earnings are facing headwinds, US banks and corporations are not facing the massive write-offs of 2008 and 2009 that brought GAAP earnings down from $80 to $7 in a short year. So be worried, but don’t panic. And if you decide to panic, you know where to go.