Friday, October 14, 2016

‘Tis the season

Economy and Markets

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ECONOMY & MARKETS | October 14, 2016

What Declining Earnings Continue to Tell Us

By Rodney Johnson, Senior Editor, Economy & Markets


'Tis the season. Earnings season, that is, and I don't think we're getting any presents.

This week Alcoa kicked off the third-quarter earnings announcement season. The next couple of weeks will bring an onslaught of numbers, excuses, deflections, and projections. Company spokesmen and CEOs will spend time explaining why their industry is soft, and how better times are just ahead.

If only we remove those sticky one-time events that seem to happen every quarter, they say, we'll realize that the core business is quite healthy, and things are looking up!

I've got a better idea. Rather than listening to the talking heads, we should simply review the results.

Taken as a whole, things aren't terrible. But they aren't very promising, either. We're struggling just to get back to where we were two years ago.

At the start of this year, the consensus estimate was for the earnings of the companies in the S&P 500 to turn positive in the second quarter. U.S. companies suffered a dismal fourth quarter in 2015 that carried over to the New Year, but surely things would get better in short order.

They have, but not by much.

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According to FactSet, we're staring down the sixth consecutive quarter of lower year-over-year earnings, which marks the first time this has happened since the company began to track earnings in the third quarter of 2008.

Last year, much of the decline was attributed to energy companies. With the price of oil falling out of bed through most of 2015 and fracking all but shut down, energy companies gushed red ink.

The carnage was supposed to stop when oil rebounded, but that hasn't happened. Oil is up more than 50% from the end of last year, and yet energy company earnings are expected to fall 63% this quarter.

But that's not the only suffering sector. Analysts cut their earnings estimates for materials, real estate, and consumer discretionary companies.

If earnings are reported as expected, we will have climbed back to levels first seen in the summer of 2014.

It sounds dismal, because it is. Yet the equity markets are near all-time highs. It's as if stock prices are celebrating, even though companies are struggling to make progress.

Recently Nike surprised the markets with better-than-expected earnings, but then disappointed with their forward guidance.

Essentially, the company said things had been pretty good lately, and enjoyed a boost from the Rio Olympics, but they didn't think the good times would last. These are interesting words, coming from a retail company that typically does well in the fourth quarter due to holiday sales.

But don't worry!

Everything is fine, right?

Analysts estimate earnings will pop 13% in 2017, so the good times will finally be here again.

I'll believe it when I see it.

And then there's the little matter of stock buybacks. Once the province of failing companies that were eager to shore up their price-earnings ratios by taking shares out of the market, stock buybacks have been all the rage since the financial crisis of 2008.

Companies are using their cash stockpiles and debt (courtesy of exceptionally low interest rates) to retire stock by the truckload. In the first quarter of this year, companies in the S&P 500 spent more than $150 billion to buy back their shares. They have spent more than $2 trillion on their own stocks since 2011.

When dividends are included with stock buybacks, companies in the S&P 500 have paid investors 112% of what they made in the first half of 2016. To put it mildly, that's unsustainable.

These three trends – falling earnings, stock buybacks, and equity market gains – make for an interesting paradox. Companies are telling us in no uncertain terms that growth remains elusive, they can't find a good use for cash, and yet stock buyers keep pushing up share prices.

Once again, I'm reminded of the old quote by economist Herbert Stein: "If something cannot go on forever, it will stop."

After seven years of growth based on shaky fundamentals, trillions of dollars in stock buybacks, and central bank action, equity markets are at risk. Make sure you have a plan for when that "something" that can't go on forever, finally stops.


P.S. Don't forget to join me, the Dent Research team and other financial luminaries like David Walker and Lacy Hunt next week at the Irrational Economic Summit in West Palm Beach, Florida. I look forward to seeing you there. And if you can't make it to the PGA National Resort Oct. 20-22 to take in our presentations and mingle in person, make sure to watch online via our live stream.

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