x
Breaking News
0

SPX Profits Up 12% YTD. What Happened To The Earnings Recession?

By Urban CarmelStock MarketsNov 28, 2016 02:44AM ET
www.investing.com/analysis/what-happened-to-the-earnings-recession-200166750
SPX Profits Up 12% YTD. What Happened To The Earnings Recession?
By Urban Carmel   |  Nov 28, 2016 02:44AM ET
Saved. See Saved Items.
This article has already been saved in your Saved Items
 

Summary: A year ago, profits for companies in the S&P had declined 15% year over year (yoy). Sales were 3% lower. Margins had fallen more than 100 basis points. The consensus believed all of this signaled the start of a recession in the US.

How has that dire prognosis worked out? In a word: terrible. Jobless claims are at more than a 40 year low and retail sales are at an all-time high. The US economy continues to expand.

In the past year, S&P profits have grown 12% yoy. Sales are 2.4% higher. By some measures, profit margins are at new highs. Why were the critics wrong? They confused a collapse in one sector—energy, where sales dropped by 60%—with a general decline in all sectors. Energy was considered the same as financials in 2007-08; events since then show that it is nothing like financials.

Where critics have a valid point is valuation: even excluding energy, the S&P is highly valued. With economic growth of 3-4% (nominal), it will likely take exuberance among investors to propel S&P price appreciation at a significantly faster annual clip.

* * *
A year ago, profits for companies in the S&P had declined 15% year over year (yoy). Sales were 3% lower. Margins had fallen more than 100 basis points. The consensus believed all of this signaled the start of a recession in the US.

The chart below was from Barclays) at the start of the 2016, who said that big drops in profitability like those last year have coincided with a recession 5 of the last 6 times since 1973 (read further here).

SPX Net Profit Margins vs Recession 1973-2016
SPX Net Profit Margins vs Recession 1973-2016


How have these dire prognoses for the US worked out? In a word: terrible. Jobless claims are at more than a 40 year low (first chart below) and retail sales are at an all-time high. US demand growth, measured a number of different ways, has been about 3-4% nominal yoy during the past two years (second chart below). There has been no marked deterioration in domestic consumption or employment.

US Initial Claims 1975-2016
US Initial Claims 1975-2016

US Personal Consumption Expenditures
US Personal Consumption Expenditures

So is the resilience of the US economy in the face of deteriorating sales and profits a surprise? Not at all. We wrote about this at the time saying that there was little in corporate reports to suggest that a recession was imminent (that post is here). Events since then bear this analysis out and provide a lesson in how to objectively read quarterly earnings reports.

Let's review the latest corporate reports. More than 90% of the S&P 500 has reported their sales and earnings for 3Q16.

Overall, sales are 2.4% higher than a year ago. This is the best sales growth since 4Q14 - almost 2 year ago. On a trailing 12-month basis (TTM), sales are just 0.2% higher yoy, but it's the first annual rise on a TTM-basis in the past 5 quarters (all financial data in this post is from S&P).

SPX Quarterly Sales per Share 2000-2016
SPX Quarterly Sales per Share 2000-2016

In the chart above, note that overall S&P sales are still about 2% lower than their peak in 4Q14. Why has sales growth been sluggish?

It's primarily due to oil prices, which peaked at the end of 2Q14 and then fell 70% before bottoming in February 2016. Energy sector sales fell by 60% between mid-2014 and early 2016 (red line). This has had a substantial impact on overall sales, as energy was one of the largest sectors in the S&P in mid-2014. Materials sales have also fallen, but the sector is very small.

SPX Sales per Share: Energy vs Materials 2011-2016
SPX Sales per Share: Energy vs Materials 2011-2016

If overall S&P sales since 2014 were indicating widespread economic weakness, then we should have expected to see declining sales growth in many sectors, not just in energy and materials. We didn't.

In the past two years, industrial sector sales are up 6%, discretionary sales are up 14%, health care sales are up 18% and financials sales are up 24%. Outside of energy and materials, only utilities have seen a decline, a loss of a mere 1% (middle column).

SPX Quarterly Sales per Share by Sector
SPX Quarterly Sales per Share by Sector

Excluding the energy sector, the combined sales of the other sectors in the S&P are back at their prior highs from 2014 and 2015 (blue line). Simply stated: corporate sales never indicated widespread weakness in the economy (from Yardeni).

SPX Aggregate Revenues: Total vs ex-Energy 2002-2016
SPX Aggregate Revenues: Total vs ex-Energy 2002-2016


That is not to say that the combined sales outside of the energy sector are strong. Ex-energy sales growth was 5-6% in mid-2014. Over the past three quarters, growth has only been about 2%. While that's not great growth, it's also not recessionary (from Yardeni).

SPX ex-Energy Revenue Growth 2000-2016
SPX ex-Energy Revenue Growth 2000-2016

Why has non-energy sales growth been sluggish?

Companies in the S&P derive about half of their sales from outside of the US. Technology and materials are the sectors most dependent on foreign sales, but even 40% of staples sales come from overseas.

Europe and Asia are the main markets outside of the US. European GDP is growing at around 2.5%. Japan grew 2.2% in 3Q16. That's slower growth than the US, but not dramatically so. Importantly, ex-US growth is better now than it was 2-3 years ago.

Euro Area GDP 2003-2016
Euro Area GDP 2003-2016

But a headwind for ex-US sales growth has been the value of those transactions measured in dollars. When the dollar rises in value, the value of sales earned abroad (in foreign currency) falls. If foreign sales grow 5% but the dollar gains 5% against other currencies, then sales growth will be zero in dollar terms.

That has been a well-established pattern for more than 30 years. The chart below compares changes in the dollar (blue line) with growth in S&P sales (red line). Over time, the importance of the dollar's value has grown as the proportion of S&P sales outside of the US has risen (from Yardeni).

SPX Revenues vs US Trade-Weighted Dollar 1995-2016
SPX Revenues vs US Trade-Weighted Dollar 1995-2016

The trade-weighted dollar began to rapidly appreciate in July 2014 (3Q14) just as sales on the S&P peaked. By the beginning of 2016, the dollar had appreciated by 25%. With half of the sales of the S&P coming from outside the US, the dollar's appreciation alone cut S&P sales by more than 10 percentage points. In the chart above, you can see that a similar fall in sales growth occurred in 1998 when the dollar also rapidly appreciated over the course of a year.

Trade Weighted USDX 1996-2016
Trade Weighted USDX 1996-2016

It's not well remembered now, but the heart of the 1990s bull market had a severe earnings recession that lasted for the better part of 1996-98. It dissipated after the affects of the dollar's appreciation had passed.

SPX: GAAP EPS 1988-2016
SPX: GAAP EPS 1988-2016

Importantly, the headwind from the dollar has started to dissipate. In 3Q16, the dollar's appreciation was only about 2% yoy. Even today, with the rapid rise in the dollar since the presidential election, appreciation is less than 4% yoy. The dollar's current value is close to where it started the year.

Broad Trade Weighted USDX 1996-2016
Broad Trade Weighted USDX 1996-2016

In summary, the sales growth for the S&P was 2.4% yoy in 3Q16. Energy continued to be the primary drag on overall sales growth, declining 18% in the past year. Looking ahead, the average price of oil was about $40 in 4Q15 versus the current price of $47. It's possible energy will soon contribute positively to sales growth.

Crude Oil Monthly 2003-2016
Crude Oil Monthly 2003-2016

Let's now look at earnings.

Overall EPS (GAAP-basis) are 11.5% higher than a year ago. This is the best EPS growth since 3Q14 two years ago. But on a trailing 12-month basis (TTM), EPS are 1.2% lower yoy. TTM EPS are still negative because yoy EPS declined six quarters in a row between 3Q14 and 1Q16.

SPX GAAP EPS Quarterly 1988-2016
SPX GAAP EPS Quarterly 1988-2016

Given the forgoing discussion on sales growth, it should come as no surprise that corporate profitability peaked right before the rapid fall in energy prices and appreciation in the dollar. In 3Q14, profit margins were 10.1%; that fell to a low of 8% in 4Q15.

SPX Operating Margins 2010-2016
SPX Operating Margins 2010-2016

In the chart above, note that margins have now rebounded to 10.0%. That's right, overall profit margins are right back at their prior highs from 2014. How is this possible?

For most sectors, margins expanded between 3Q14 and 3Q16 (second column). The big outlier was energy. Energy had an outsized effect on overall margins and falsely indicated a high risk of recession.

SPX Quarterly Operating Margins, by Sector
SPX Quarterly Operating Margins, by Sector

SPX Operating Margins: Industrials:Discretionary:Staples;Healthcare
SPX Operating Margins: Industrials:Discretionary:Staples;Healthcare

SPX Operating Margins:IT:Utilities:Real Estate:Financials
SPX Operating Margins:IT:Utilities:Real Estate:Financials

Recall that sales growth for energy companies fell by 60% between mid-2014 and early 2016. Even with flat margins, energy profits would have also fallen 60%. But energy profit margins fell from 9% in 3Q14 to negative 11% in 4Q15. This one sector was the source for nearly all of the decline in the overall margins from 3Q14 to 4Q15.

Operating Margins 2010-2016, Energy vs Materials
Operating Margins 2010-2016, Energy vs Materials

Without the negative drag from energy, total margins for the S&P are now higher (10.7%) than they were in 3Q14 (10.3%). Margins are at a new high.

SPX Operating Margins: SP500 ex-Energy vs Total SP500
SPX Operating Margins: SP500 ex-Energy vs Total SP500

In summary, the EPS growth for the S&P was 11.5% yoy in 3Q16, the highest quarterly growth in two years. Overall profit margins are back at their former highs from 2014. Nearly all of the interim weakness in profitability was related to weakness in energy. That the other sectors showed continued strength was a very strong indication that corporate results were not indicative of an imminent recession (from Yardeni).

SPX Profit Margins 2002-2016
SPX Profit Margins 2002-2016

Weakness in energy was a very clear outlier since late 2014. The point of excluding energy has not been to imply that actual S&P results are better than they are. By excluding energy companies' financial results, we can see what the underlying trend for the rest of the S&P is.

Over the past two years, there have been several knocks on the practice of excluding energy from the other sectors. Most of these miss a basic truth: that in the past, large drops in energy sales and profits have falsely signaled economic risks that did not then materialize. We detailed all of these issues in the past (see article link, above). Below is a quick recap:

Excluding energy is not "like excluding technology in 2000 or financials in 2007". Technology and financial stocks were in a bubble in 2000 and 2007, respectively; their market capitalization weighting in the S&P reached an extreme ahead of both of the subsequent bear markets. That was not at all the case for energy in 2014.
The environment since 2014 is nothing like 2006-07 because financial excesses in the banking sector are completely unlike excesses in energy or any other sector. Banks that are excessively leveraged are at risk of failure; when they retrench, lending to the rest of the economy is reduced, creating a drop in investment and consumption and a recession. Banks are a source of systemic risk; other sectors are not.
Lower gas prices do not materially impact other consumer spending. Gas represents only 5% of a typical family's consumer spending.
Lower oil prices don't have a notable positive impact on margins for most of the other large sectors. The importance of oil as an input cost is too minor. Note that most facility energy is produced using coal, natural gas, nuclear power and renewables.

That the drop in energy since 2014 once again has not resulted in an economic recession shows that excluding energy in an analysis of sales and profits was right.

Let's also update two other misconceptions about earnings.

The first is that corporate buybacks have been the main source of profit growth. This is false; almost 90% of the growth in earnings in the S&P since 2010 has come from better profits, not share reductions. This is a topic we have specifically addressed before (most recently here).

SPX Growth Sources 2Q10-3Q16
SPX Growth Sources 2Q10-3Q16

The second misconception is that "operating earnings" have abnormally deviated from earnings based on GAAP in recent quarters. It is true that earnings are both overstated and smoothed on an operating basis, but that has been the case over several decades. This is not new.

SPX: Operating vs GAAP EPS 1988-2016
SPX: Operating vs GAAP EPS 1988-2016

The difference between operating and GAAP earnings is now about 12%, which is close to the median over the past 25 years. Operating earnings overstated profits by much more in the 1990s bull market and earlier in the current bull market. The biggest differences have always been during bear markets.

SPX Difference Between Operating vs GAAP EPS
SPX Difference Between Operating vs GAAP EPS


* * *
In summary, S&P profits have grown 12% in the past year. Sales are 2.4% higher. By some measures, profit margins are at new highs. Why were the critics, who expected weak sales and profits a year ago to be a signal of an imminent recession, wrong? They confused a collapse in one sector - energy, where sales dropped by 60% - with a general decline in all sectors. Energy was considered the same as financials in 2007-08; events since then show that it is nothing like financials.

Where critics have a valid point is valuation. Even excluding the troubled energy sector, valuations were rich at the end of 2014 and remain so today. These valuations are at the same level as in mid-2007 when the prior bull market ended (from Yardeni).

SPX ex-Energy, Forward Earnings and Valuation 2007-2016
SPX ex-Energy, Forward Earnings and Valuation 2007-2016

With economic growth of 3-4% (nominal), it will likely take exuberance among investors to propel S&P price appreciation at a significantly faster annual clip. Why? When investors become bullish (blue line), valuations rise (red line). Investors have most recently been pessimistic; they are now neutral. If oil prices and the dollar stabilize, earnings growth may be only 3-5% TTM yoy but valuations could push the equity market much higher (from Yardeni).

SPX Forward P/E vs Bull/Bear Ratio 1988-2016
SPX Forward P/E vs Bull/Bear Ratio 1988-2016

SPX Profits Up 12% YTD. What Happened To The Earnings Recession?
 
SPX Profits Up 12% YTD. What Happened To The Earnings Recession?

Add a Comment

Comment Guidelines

We encourage you to use comments to engage with users, share your perspective and ask questions of authors and each other. However, in order to maintain the high level of discourse we’ve all come to value and expect, please keep the following criteria in mind: 

  • Enrich the conversation
  • Stay focused and on track. Only post material that’s relevant to the topic being discussed.
  • Be respectful. Even negative opinions can be framed positively and diplomatically.
  •  Use standard writing style. Include punctuation and upper and lower cases.
  • NOTE: Spam and/or promotional messages and links within a comment will be removed
  • Avoid profanity, slander or personal attacks directed at an author or another user.
  • Don’t Monopolize the Conversation. We appreciate passion and conviction, but we also believe strongly in giving everyone a chance to air their thoughts. Therefore, in addition to civil interaction, we expect commenters to offer their opinions succinctly and thoughtfully, but not so repeatedly that others are annoyed or offended. If we receive complaints about individuals who take over a thread or forum, we reserve the right to ban them from the site, without recourse.
  • Only English comments will be allowed.

Perpetrators of spam or abuse will be deleted from the site and prohibited from future registration at Investing.com’s discretion.

 
Are you sure you want to delete this chart?
 
Write your thoughts here
 
Replace the attached chart with a new chart ?
Post
Post also to:
1000
Your ability to comment is currently suspended due to negative user reports. Your status will be reviewed by our moderators.
Please wait a minute before you try to comment again.
Thanks for your comment. Please note that all comments are pending until approved by our moderators. It may therefore take some time before it appears on our website.
Comments
demis ili
demis ili Nov 28, 2016 1:10PM GMT
Saved. See Saved Items.
This comment has already been saved in your Saved Items
very informative article and good analysis of the facts.If you have the time and resources can you please give a forward guidance for US growth should the dollar remain bullish and reaches parity against the EUR?
Reply
0 0
Joe Regan
Joe Regan Nov 28, 2016 11:50AM GMT
Saved. See Saved Items.
This comment has already been saved in your Saved Items
a well done article
Reply
0 0
 
Are you sure you want to delete this chart?
 
 
Replace the attached chart with a new chart ?
Post 1000
Your ability to comment is currently suspended due to negative user reports. Your status will be reviewed by our moderators.
Please wait a minute before you try to comment again.
Add Chart to Comment
Confirm Block

Are you sure you want to block %USER_NAME%?

By doing so, you and %USER_NAME% will not be able to see any of each other's Investing.com's posts.

%USER_NAME% was successfully added to your Block List

Since you’ve just unblocked this person, you must wait 48 hours before renewing the block.

Report this comment

I feel that this comment is:

Comment flagged

Thank You!

Your report has been sent to our moderators for review
Disclaimer: Fusion Media would like to remind you that the data contained in this website is not necessarily real-time nor accurate. All CFDs (stocks, indexes, futures) and Forex prices are not provided by exchanges but rather by market makers, and so prices may not be accurate and may differ from the actual market price, meaning prices are indicative and not appropriate for trading purposes. Therefore Fusion Media doesn`t bear any responsibility for any trading losses you might incur as a result of using this data.

Fusion Media or anyone involved with Fusion Media will not accept any liability for loss or damage as a result of reliance on the information including data, quotes, charts and buy/sell signals contained within this website. Please be fully informed regarding the risks and costs associated with trading the financial markets, it is one of the riskiest investment forms possible.
Continue with Google
or
Sign up with Email