Do Earnings Matter?

Per ThomsonReuters, the “forward 4-quarter” earnings estimate for the S&P 500 rose a smidge this week, to $113.32, from last week's $113.22.

The forward P/E ratio with Friday, June 14th’s close is 14.36(x).

The “earnings yield” on the S&P 500 using the forward estimate is 6.97%.

The year-over-year growth of the forward estimate is now 4.82%, and moving higher once again.

The current full-year 2013 consensus earnings growth estimate for the S&P 500 is 7.5%, which at its current value of roughly 1,600, leaves the S&P 500 fairly valued on a P/E.-to-growth basis of 2(x).

Do earnings and earnings growth matter?

ISI’s Dennis Bebusschere published an article (ISI Portfolio Strategy, Early Thought, Thursday, June 13, 2013) this past week showing no correlation between historical S&P 500 earnings growth and S&P 500 returns. That was somewhat of a shock to read, and negates the need for an earnings-related blog (such as this one). Dennis concludes that “EPS growth is an important part of equity returns, but it is only one piece of the equation.”

Both Dennis and Jim Tanious of JP Morgan think that this latest bull market is all about P/E expansion since Dennis says that “the latest run in equities is all about normalizing multiples than earnings growth. In fact, without multiple expansion, the S&P 500 would be roughly 400 points lower today.”

ISI concludes that valuations are still reasonable, and that “earnings growth, though clearly not the main driver of returns, has been supportive of the market.”

Jim Tanious of JP Morgan wrote something similar about a month ago, but basically said that forward returns on the S&P 500 would be from P/E expansion, rather than earnings growth.

My two cents in this discussion is that while both of these guys are far smarter than I am with better access to reams of earnings data which they can sift through statistically, readers should pay close attention to that “forward 4-quarter” estimate we provide every week, and more importantly the “rate of change” of the forward estimate. My own opinion is that this statistic i.e. the FORWARD EARNINGS estimate, carries more freight than we think, very few sources track this stat, and we rarely hear it quoted.

ISI does some great research. We follow Dr. Mark Schoenebaum’s work on large-cap pharma, and he is stellar.

Ultimately, I can’t see how earnings and earnings growth don’t matter, but to Dennis’s point, their importance to S&P 500 returns likely varies over long-time periods.

A better question might be, for us navel-gazers, is what causes P/E expansion or contraction ? My impression is that the market P/E expands and contracts when earnings growth accelerates and decelerates. So then,we ask the question again, ”Do earnings matter ?” (I say, “yes, for sure.”)

Here is one of our original posts on this blog from last year on 12 years of P/E contraction. Today, the forward multiple is 14.5(x) and the forward estimate is $113. I need to update this post and turn it into a legible spreadsheet for readers.

With 497 of the S&P 500 having reported Q1 ’13 earnings, the close-to-final results are that the S&P 500 saw +5.4% year-over-year (y/y) earnings growth, on flat revenue growth.

This week, we start to hear from companies with May quarter end including Fedex (FDX) Wednesday morning, Micron (MU) Wednesday night, and Oracle (ORCL) Thursday night, June 20th. (Long all 3 names.)

Here is our FedEx Corp (FDX) preview.

Here is our Micron (MU) preview.

Micron is seeing firming DRAM prices but the economics of the business longer-term have been horrid. Supposedly that could be changing. Note the 12 year capex growth versus the 12 year cash-flow growth. Sisyphus.

FedEx is one of our favorite longer-term picks. It is a “return to global growth” play. FDX might require some patience.

When Q2 ’13 earnings start in mid-July, I expect it to be more of the same, i.e. 4% – 6% growth as we saw in Q4 ’12 and Q1 ’13. This week’s reports will tell us how business tracked through May.

Interesting Stat: Financial sector y/y earnings growth by Quarter for 2013

(As of Friday, June 14th, April 1 and January 1)

Q4 ’13: +25%, +24.6% and +26.1% (estimated)

Q3 ’13: +12.3%, +11.3%, and +12.2% (estimated)

Q2 ’13: +18.3%, +17.6% and +19.2% (estimated)

Q1 ’13: +18.3%, +11%, and +9.6% (now almost final)

So far our earnings assumptions have been pretty good, and I would bet that the 2nd quarter, ’13′s expected rate of growth of 18% is underestimated, by as much as 7%. I think financials could do +25% earnings growth in Q2 ’13 led by the IPO markets, debt underwriting and overall steady improvement in credit and capital markets. The month of May may have hurt a little given the back-up in Treasuries, but overall the capital market and commercial banking tailwinds are favorable.

Note the expected growth for financials in Q4 ’13. That is huge, and portends very well for the capital markets, in my opinion. That is late 1990′s type growth, and that is NOT getting revised lower (yet).

Stay with financials: Goldman (GS), Charles Schwab (SCHW), and CME (CME) are our top favorites. CME didn’t budge an inch this past week, despite the volatility in the S&P 500. (Long all 3 names.)

Odds-and-Ends from our reading:

Ryan Detrick, a great technician out of Cincinnati and Schaffer’s Investment Research, shows this graph/table on the DJIA. Sure seems bullish to me.

Bob Brinker, tweeted a Bloomberg article on junk-bond volume, through the first 6 months of 2013. It is tough to be negative on high-yield without being negative on the US economy and earnings growth, and I don't see that. The point of the Bloomberg article, which I think Brinker is trying to emphasize, is that 2nd tier loans are a form of “covenant slipping” in the high yield market, so the quality of the high yield issuance might be declining.

Moody’s has written a few times about this since the first of the year. Personally, I think overweighting credit risk into year end 2013 should help investors get positive returns in a flat to mixed bond market.

Nancy Lazar, the lead economist of the CornerStone Macro team that spun out of ISI, wrote this past week that the Federal Deficit has shrunk from -10% to -5% of GDP. That is amazing (to me). Certainly GDP growth helps, as have the tax hikes, Fiscal Cliff and sequester. Wish I could attach the chart / PDF. (Nancy does great work – paired with Ed Hyman at ISI for a while. Nancy was early on the housing recovery and pushing its durability.)

Another good Josh Brown article. He is exactly right, i.e. the constant need to “explain” the day-to-day market action. Some producers no more know why the market moved that day in the direction it did, than why the weather was the way it was that day.

Helene Meisler of theStreet.com on the put/call ratio. Again, seems bullish to me.

Good chart from Gary Morrow, TheStreet.com, Deere (DE). This could be another “return-of-global-growth” play, like Caterpillar (CAT). No positions yet in DE, small long in CAT.

Summary:
The S&P 500 continues to sit above its 50 day moving average and the early June lows at 1,600. It sure looks like we had a double-bottom in the S&P 500 this past week, but time will tell.

My own technical analysis tells me that if we take out 1,600 to the downside, then the October ’07 highs near 1,575 – 1,577 will be a very important level. The election, Fiscal Cliff Sequester – all that is now gone from the anxiety tree. The end of 2013 could be very good.

Strategic: In equities, remain overweight equities when allowing for the standard 60% /40% stock bond portfolio. Client portfolios vary by client- given differences, etc. but most are overweight equities with a 65% or 70% allocation, with the difference being fixed income. We are out of gold, and have been for some time.

Tactical: we are overweight financials, technology and industrials as we await the return-to-global-growth to play out. We own no telco or utilities, no REITs and sold our homebuilders. All large-cap exposure. Very little mid and small-cap exposure.

Tactically in fixed income we are overweight credit risk, and like everybody else have shortened duration. Client accounts now hold anywhere from a 10% to 30% position in the unlevered Inverse Treasury (TBF).

What makes me very nervous about our short Treasury position is that so many have been so right, at the same time, about calling the top in Treasuries. Bill Gross, and even a couple of clients, thought we had topped in May. Everyone is bearish, except Gundlach and he is only mildly bullish. All that one-sided sentiment makes me nervous, and might actually delay or prolong “The Great Rotation”.

Actually, the iShares Core Total US Bond Market Fund (AGG), Verizon (VZ), AT&T (T) and the high yield ETFs look ready for a bounce. We might add for a trade.

One last thought: Doug Kass (in the last few years), the legendary hedge-fund manager and blogger at TheStreet.com, has used the famous saying by Hyman Roth from Godfather II, “This is the business we’ve chosen” to help articulate the struggles of being an investment advisor for sometimes hot-tempered clients, and to help rationalize frustrating markets. It was March, 2002, and it was nearing the final phase of the technology and large-cap growth bear market, and I was driving down to the Southwest Burb’s of Chicago to see my Mom in the nursing home, as she had just been moved into hospice.

My Mom endured a 10-year battle with Alzhemier's and that weekend was particularly tough for reasons I won’t get into on this site. During the car-ride south, as the family was summoned to the nursing home, I got a call from an irate client who just reamed me a new one through the phone, and went on and on, and two hours later my Mom died. Now, I drove back to the office after leaving the nursing home, and wasn’t feeling good about the last two years anyway, and while sitting at my desk alone late in the day, I thought “If this person were put in front of me right now, I think I’d beat ‘em into a coma.”

However, the very next thought, deep from the wisdom of ages, was “This is the business you are in – if you don’t like it when client’s get angry, find another business.”

Nothing was ever said about this to the client, but they stayed on for years, although eventually leaving, and in fact it became a good relationship and friendship.

I hear and read investors complain all the time about clients: sure, there are instances when you probably need to sever a relationship, but ultimately “This is the business we’ve chosen”. Handle the emotion or sell cars.