Morgan Stanley Says An ‘Earnings Recession’ Has Arrived (#GotBitcoin?)
The long-awaited earnings recession has finally arrived, but investors are still too optimistic and should anticipate more disappointment as the year drags on, according to Morgan Stanley. Morgan Stanley Says An ‘Earnings Recession’ Has Arrived (#GotBitcoin?)
* Morgan Stanley equity chief Mike Wilson, who first predicted a contraction in earnings growth in 2018, lowers his 2019 S&P 500 EPS target to 1 percent from 4.3 percent.
* “We are increasingly convinced that consensus earnings expectations for 2019 have further to fall,” Wilson writes in a note to clients.
* A host of market data researchers including FactSet and S&P predict a decline in S&P 500 earnings in the first quarter of 2019.
* Wilson was the most accurate Wall Street strategist tracked by CNBC in 2018 and has issued a streak of bearish calls about the S&P 500 and earnings performance.
Mike Wilson, the firm’s chief U.S. equity strategist, lowered his 2019 S&P 500 earnings per share growth expectation to 1 percent from 4.3 percent based on the many downward profit revisions during the fourth-quarter reporting season.
And while consensus numbers are already pricing in zero growth for the first half of this year, Wilson contended that predictions for a re-acceleration in the second half of 2019 are misplaced. He said the year could end with earnings down as much as 3.5 percent overall.
“We are increasingly convinced that consensus earnings expectations for 2019 have further to fall and that the optimistic uptick currently baked into fourth-quarter 2019 estimates is unlikely,” Wilson wrote Monday. “A modest further decline in earnings will deliver the earnings recession we called for. Equity returns can still be positive in this environment, but they will likely be weaker than they otherwise would have been.”
Wilson, who first predicted an earnings recession in 2018, now sees 2019 S&P 500 EPS at $164, below the consensus estimate of $170.
The strategist added that when investors have assumed a jump in earnings growth four quarters out in the past, the numbers for all four quarters ahead tend to fall but the growth quarter tends to fall the most. In fact, if current estimates move in line with history, investors could see a full-year decline of 3.5 percent in S&P earnings, he wrote.
About 66 percent of the S&P 500 has reported fourth-quarter 2018 earnings thus far. While nearly 70 percent have topped analyst expectations on the bottom line, only 60 percent have surprised to the upside on revenue. Looking ahead, Refinitiv joined other market data researchers FactSet and S&P last week in predicting a decline in S&P 500 earnings in the first quarter of 2019.
FactSet predicted a first-quarter earnings loss of 2.1 percent as of Monday morning.
“Downward revisions have come even faster and steeper than we expected and the [consensus] full year earnings growth number now sits just above 5 percent with a material upward acceleration projected in the fourth quarter,” Wilson told clients. “At the start of a downward revisions cycle, history tells us not to count on that kind of upward inflection.”
Wilson was the most accurate Wall Street strategist tracked by CNBC in 2018 and has issued a streak of bearish calls about the S&P 500 and earnings performance over the past year. He did not adjust his current 2019 S&P 500 year-end price target of 2,750.
That estimate is the lowest of 2019 and implies less than 2 percent upside from Friday’s close. Wilson has repeatedly warned of dismal results in equities and said investors could be caught in a “rolling bear market” for the next several years with the S&P 500 trading in a range of 2,400 to 3,000.
Better-Than-Expected Earnings Ease Growth Fears—for Now
Corporate profits haven’t waned as much as analysts had predicted.
Investors are breathing sighs of relief that corporate profits haven’t waned as much as feared, giving new life to a stock-market rally that had largely stalled since the summer.
Although earnings are on track to decline for the third consecutive quarter, about 75% of the 342 companies in the S&P 500 that have posted results through Thursday morning have beaten expectations, according to FactSet. That is slightly above the five-year average of 72%. Dozens of companies report through the end of the week.
While overall profits are expected to fall about 2.7% from a year earlier, the steepest decline since 2016, most analysts have called a bottom. They project earnings growth to accelerate next year, helping to allay fears of a potential recession.
“Earnings…are truly better than expected,” said Peter Vanderlee, a portfolio manager at ClearBridge Investments who helps oversee $22 billion in assets. “As a result, there hasn’t been a moment where you would say, ‘Look, it is upon us. A recession is nearing.’”
Companies including Intel Corp. , Johnson & Johnson and United Technologies Corp. raised their outlooks for the year after posting strong financial results. Intel logged record quarterly revenue, easing concerns about softening demand for its products. Johnson & Johnson said sales of such consumer products as Band-Aid bandages and Tylenol grew, while United Technologies said it expects sales to keep rising.
Some investors caution that expectations for 2020 are too high. Earnings are expected to rise 5.7% and 7.1% for the first and second quarters, respectively, FactSet data show, following a roughly flat performance in the last three months of this year.
And more companies have been lowering earnings forecasts than raising them. Thirty-nine companies in the S&P 500 have issued negative outlooks, compared with 15 giving positive guidance, according to FactSet.
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“Essentially all of us came into the earnings season with very low expectations,” said Supriya Menon, senior multiasset strategist at Pictet Asset Management. “The problem is that earnings expectations are still too high next year.”
It isn’t unusual for companies to beat earnings expectations because the bar can be low to begin with, as companies manage expectations. The latest results helped push the S&P 500 to a fresh record this week for the first time in three months. The index, which is up 21.5% in 2019, had faced resistance breaking out of a narrow trading range in recent weeks. It has climbed 2.4% in October.
Mr. Vanderlee said he has been impressed by results from such big banks as JPMorgan Chase & Co., which posted strong growth and highlighted the strength of the U.S. consumer, a key engine of growth. He said he expects corporate earnings to expand next year.
“The fears of a recession have been high for the past six to nine months,” said Brent Schutte, chief investment strategist at Northwestern Mutual Wealth Management. “Earnings have certainly helped put some of that to rest.”
Also helping ease concerns about the economy, data on Wednesday showed gross domestic product rose at an annual rate of 1.9% from July through September, a slowdown from the second quarter but above the expectations of economists surveyed by The Wall Street Journal.
Investors will get another glimpse of the health of the domestic economy when the monthly jobs report is released Friday. The latest figures showed unemployment hovering at a 50-year low.
Still, there are signs that a stronger U.S. dollar, waning economic growth around the world and the U.S.-China trade dispute have been weighing on companies, especially those more reliant on overseas business.
For some, the latest earnings season has highlighted the strength of the U.S. economy relative to others around the world, especially with the continuing trade battle between the U.S. and China. Though tensions have eased lately, the countries haven’t reached a final pact, and many investors fear that relations could sour in coming months. These concerns came to the forefront Thursday, weighing on U.S. markets in early trading.
“The companies that are more domestically focused are doing quite well,” said Hans Olsen, chief investment officer at Fiduciary Trust Co., which oversees $7 billion in assets under management. “The ones overseas are really struggling…There’s a notable lack of robust growth around the world.”
S&P 500 companies deriving a bigger share of revenues from the U.S., rather than abroad, have fared betterthis earnings season.
Companies in the S&P 500 with relatively high international exposure are poised to underperform those that derive a bigger chunk of revenue domestically. Those that get less than 50% of revenue from the U.S. are on track for an 8.6% earnings decline and a 2.4% fall in revenue, FactSet data show, compared with a more modest 0.3% earnings decline and 4.9% jump in revenue for those that generate more than half of their revenue in the U.S.
Ford Motor Co. and Caterpillar Inc. have been among the companies that have pointed to international headwinds. Ford’s quarterly results beat estimates, but executives said weakness in China will crimp earnings, dimming its outlook for the year. Caterpillar executives said that global economic uncertainty is weighing on profits.
“We’re clearly not satisfied with our standing in China, and the team is working exhaustively to return to profitable growth in this important market,” Ford Chief Executive James Hackett said on the company’s latest earnings call on Oct. 23.
In contrast, Microsoft Corp. , which gets more than half its revenue from within the U.S., according to FactSet, recorded per-share earnings and revenue that beat analysts’ expectations thanks to strength in its cloud-computing business. Its shares set a record Wednesday.
Companies’ Core Earnings Are More Crazily Distorted Than Investors Realize, And That Puts Stocks At Risk
Over the trailing 12 months, GAAP earnings fell 1% while adjusted core earnings fell 6%.
The earnings recession is not news. What most investors don’t know is that core earnings, when adjusted for unusual gains and losses hidden in footnotes, are a lot worse than they realize.
Meanwhile, the S&P 500 index SPX, has been on a tear this year, up nearly 25% and currently around an all-time high.
How Do Stocks Rise When The Underlying Fundamentals Fall?
Answer: Most Investors Are Not Aware Of The More Severe Decline In Core Earnings.
Why Are They Not Aware?
Answer: Because Too Few People Read The Footnotes.
Adjusted Core Earnings Drop Below Gaap Earnings For The First Time Since 2006
Over the trailing 12 months, GAAP earnings fell 1% while adjusted core earnings fell 6% for the largest 1,000 companies by market capitalization in each period. Most investors know that GAAP earnings are prone to distortion because they include lots of non-recurring or unusual items. Most investors are not aware that core earnings (from CompuStat or Wall Street analysts) are also distorted by unusual items. In fact, earnings for the S&P 500 were distorted by 22% on average in 2018.
High levels of earnings distortion means companies are overstating their earnings; so there is a greater risk of their missing their earnings targets. Negative or lower levels of earnings distortion mean the opposite.
The Companies Most Likely To Miss Earnings Overstated Their Core Earnings By Including A Variety Of Unusual Gains, Including:
• A $7.3 Billion One-Time Gain Due To The Impact Of The Corporate Tax Cut For Broadcom
• A $2 Billion Unrealized Gain On Securities For Constellation Brands
• A $3.3 Billion Gain On Sale Of Businesses For Linde
On the other hand, large asset write-downs are the cause of the understated earnings for all the companies most likely to beat.
Why The Severe Drop In Core Earnings?
Earnings distortion from hidden gains is on a rapid rise, and core earnings from traditional sources have not been this overstated since 2000. Figure 3 shows the level of core earnings distortion from the unusual gains and losses from 2000 to the present. Note the rapid rise in the distortion from gains buried in footnotes over the last few years.
The rapid rise in earnings distortion since 2015 means that an increasing amount of corporate income is coming from unusual or one-time gains, which is not apparent to investors analyzing news releases or income statements. Corporate managers hide the one-time nature of these gain by only disclosing them in the fine print. In other words, managers are dressing up the numbers in an increasingly aggressive manner over the last few years.
Notably, earnings distortion is now positive for the first time since 2007 and is the highest it’s been since 2000. Figure 3 shows that soon after earnings distortion broke into positive territory, in 2006-07 and 1998-2000, the stock market crashed.
Catalyst For A Market Correction
We Know That The Federal Reserve Plans To Leave Interest Rates Unchanged For The Near Future, So There Are Two Likely Catalysts For A Market Correction:
1. Companies Suddenly Report Core Earnings More Accurately.
2. Investors Figure Out The True Core Earnings.
The odds of the first option are lower than the second. We’re not holding our breath that investors will suddenly decide to spend hours scouring footnotes and adjusting their numbers for the hidden gains and losses that managers use to manipulate earnings. It is more likely, however, that investors would start using research that does the footnotes research for them
The only remaining question is how quickly investors adopt this research. We are not sure how to answer that question except to say that those who adopt sooner have an advantage over those that adopt later.
Earnings Distortion Reveals A Stock To Avoid
Some stocks are more risky than others.
We created the Earnings Distortion Scorecard to help investors identify stocks most at risk of an earnings miss due to accounting distortions, and Northrop Grumman is currently near the top of the list.
We previously warned investors about Northrop Grumman in our article “Earnings Distortion Makes This Stock a Sell”. The stock is up 45% so far in 2019, and the company has beat earnings expectations in all three quarters. However, our analysis shows that these earnings beats are the product of non-operating items.
Over The Trailing-12-Month Period, Northrop Grumman Had $415 Million In Net Unusual Income Adjustments That Cause Earnings To Be Overstated. Notable Unusual Gains Include:
• $440 Million ($2.61 Per Share) In Non-Operating Pension Gains — Page 72 Of The 2018 10-K
• $82 Million ($0.49 Per Share) In Company-Defined Other Expenses — Page 1 Of The Third-Quarter 2019 10-Q
• $84 Million ($0.49 Per Share) In Non-Recurring Tax Benefits — Page 62 Of The 2018 10-K
Northrop Grumman’s GAAP earnings per share are up 24% over the trailing 12 months, but its core earnings per share are up just 3%.
Meanwhile, Northrop Grumman’s valuation implies that it will continue to grow profits at the rate of GAAP EPS rather than core earnings. Our reverse discounted cash flow (DCF) model more rigorously assesses the valuation of this stock by quantifying the expectations for future profit growth baked into the stock price.
When we look at the expectations implied by its valuation, the stock looks much more expensive. In order to justify its valuation of $356/share, Northrop Grumman must improve its NOPAT margin to 10% (up from 9% in 2018) and grow NOPAT by 7% compounded annually for the next 10 years. This seems ambitious for a company that has grown NOPAT by just 3% compounded annually over the past decade. See the math behind this dynamic DCF scenario.
If Northrop Grumman maintains its 2018 NOPAT margin of 9% and grows NOPAT by 3% compounded annually over the next decade, the stock is worth $224 a share today, a 37% downside to the current stock price. See the math behind this dynamic DCF scenario.
Investors who want to stay safe in an increasingly dangerous market should avoid companies with overstated earnings, like Northrop Grumman.
Huge Disparity in Corporate Profits Hints at Something Amiss
Some worry that gap between weak profits in official government data and record earnings of S&P 500 repeats warning signs of late 1990s.
Are U.S. companies making more money than ever before, or are they mired in one of their longest profit slumps since World War II? Widely used measures have diverged in recent years, leaving many investors worrying that something is amiss.
Look at pretax domestic profits as measured by the Bureau of Economic Analysis, and it is easy to be bearish. Profits are down 13% in five years, the biggest drop outside a recession since World War II. President Trump’s tax cut has cushioned the blow to earnings, with after-tax corporate profits falling only a little. Profit margins also are down sharply, with the pretax margin for domestic business lower than the postwar average and below where it stood from World War II until 1970.
Falling domestic profits suggest companies are in deep trouble, avoiding an even deeper slump only thanks to tax cuts.
Earnings by S&P 500 companies tell the opposite story. Reported earnings per share were at a record in the 12 months to June, up 31% in five years and forecast to keep rising. The after-tax profit margin is slightly down from a record last year, but still higher than any time before that.
Some investors are worrying that the gap between the weak profits and the record per-share earnings of the S&P 500 is a repeat of the warning signs of the late 1990s, when listed companies exaggerated their figures. There is probably some of this. Some such excesses usually build up during long periods of economic growth.
Another factor: High S&P profits have led many to conclude that U.S. businesses are raking in money in a way more consistent with oligopoly than a free market.
A deep dive into the numbers suggests most or all of the gap is explained by other elements. Much of the gap between S&P earnings and the national figures appears to be due to tax dodging by multinationals, the troubles of smaller businesses and that the big-company index includes more successful companies than the wider economy.
Stripping out tax narrows the gap. That is because big companies benefited more from the tax cuts than small businesses. Goldman Sachs analysts point out that the tax rate on the S&P dropped by 8 percentage points, from 26% to 18%. The economywide corporate tax take dropped by a smaller 5 points from 16% of profits to 11%, partly because the economywide data includes nonprofits and corporate structures where the tax is paid by the shareholders, not the company.
The rising use of tax havens to shift offshore patents and other intellectual property rights—and their fat profits—probably makes up much of the remainder. Figures here are sketchy. Researchers at the Minneapolis Federal Reserve last year estimated that roughly $280 billion of profits had been shifted by U.S. companies offshore in 2012. That would equate to tax revenues of as much as $100 billion. Add that back in, and after-tax profits are at a record, as with the S&P.
S&P profit margins before tax fit this pattern, too. They peaked in 2014, and have come down a little since then, though by less than the fall in margins. This suggests in part that a pickup in wages has started to eat into margins in the past few years, rather than being about the internet giants creating new monopolies.
However, Jonathan Tepper, author of “The Myth of Capitalism” and founder of research house Variant Perception, says the drop in pretax margins is a result of being late in the economic cycle, and is compatible with reduced competition leading to a multidecade trend higher in profitability.
Internet giants such as Alphabet and Facebook have skewed the numbers, though, along with other successful technology stocks. S&P 500 companies are far more profitable than small and midsize listed companies, in part because of the much heavier weighting of the tech sector in the blue-chip index.
Accounting shenanigans might play a part. As independent economist and author Andrew Smithers points out, CEOs were given incentives by bonus structures to overstate public-company write-downs in 2008 and 2009. That likely boosted stated profits, and bonuses, in later years.
The next bust will probably reveal accounting misdeeds from the long stock market boom, if history is any guide. The profits disparity can mostly be explained with tax, size and sector differences. But we will only know for sure when the market next crashes.
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