The Profits Problem

The Profits Problem
Tuesday, March 1, 2016

See the pdf and the collection of the individual charts linked below.(1) Economy good. Earnings not so good. (2) Google reports more searches for “recession.” (3) The profits cycle drives the business cycle. (4) Unprofitable companies are retrenching, particularly in Energy and Materials sectors. (5) Jobless claims remain surprisingly low in oil-patch states. (6) A tough earnings season. (7) Forward earnings is a good leading indicator, but misses recessions. (8) The dollar is a drag. (9) Overall revenues growth and profit margins weighed down by Energy and Materials. (10) Other sectors still showing good revenues and margins.

Strategy I: Earnings & the Economy. Yesterday, Debbie and I observed that the US economy started the new year on lots of upbeat notes. However, we also updated our analysis of corporate profits, which remains downbeat. Earnings misses contributed to the 10.5% plunge in the S&P 500 since the start of the year through the recent low of 1828.09 on February 11. But February’s batch of US economic indicators has been surprisingly strong, helping to boost the index from that low by 5.6% through yesterday’s close. No wonder that the S&P 500 has been so choppy so far this year.

We obviously are pleased by the recent performance of the economy since we aren’t predicting a recession anytime soon. Our optimistic outlook appeared less credible over the past two months as perma-bears came out of hibernation, with one particularly vocal polar bear vociferating about an imminent “Ice Age.” A Google search in the US shows that the word “recession” jumped from an “interest-over-time” index of 25 at the end of last year to 94 in late January and 100 in mid-February. It was back down to 76 at the end of last month.

Nevertheless, Debbie and I are concerned about the weakness in profits. That’s because we believe that the business cycle is mostly driven by the profits cycle, though causality obviously runs both ways. Our main point is that profitable companies hire workers and expand capacity; unprofitable companies retrench in an effort to restore profitability. The Energy and Materials sectors certainly provide lots of examples of these distressed companies that currently are cutting their payrolls and capacity.

As we’ve shown before, there is a very good correlation between the yearly percent change in S&P 500 forward earnings (which tends to be a good leading indicator for actual profits) and the yearly percent changes in both aggregate weekly hours worked and real capital spending (Fig. 1 and Fig. 2). Forward earnings is up only 0.7% y/y through late February, while hours worked is up solidly, with a gain of 2.1% through January, and capital spending in real GDP is up just 1.6% y/y through Q4. (See ourForward Earnings & the Economy.)

As we noted yesterday, the weakness in capital spending is mostly attributable to the Energy sector, as is much of the weakness in profits over the past year. So far, there is no evidence that the profits problem is depressing the labor market. Initial unemployment claims averaged 272,000 over the past four weeks (Fig. 3). Even in the four major oil-producing states (Texas, North Dakota, Ohio, and Pennsylvania), jobless claims remain remarkably low (Fig. 4).

Here’s more on earnings:

(1) This year. January’s Q4-2015 earnings season was full of disappointments that caused analysts to cut their estimates for this year (Fig. 5). Their consensus 2016 estimate for the S&P 500 has fallen 4.3% from $126.91 per share at the start of the year to $121.48. That suggests earnings growth of only 3.5% for the year. We think consensus 2016 earnings will decline further to around $119 and that growth will be just 0.6%.

(2) This quarter. The analysts have taken an axe to their Q1-2016 estimate, which is down 7.6% since the beginning of the year and suggests Q1 earnings will be down 5.9% y/y. We’re estimating an earnings decline of 3.8% after the usual positive earnings surprise bounce. But that still would mark the worst quarter for earnings growth since Q3-2009 (Fig. 6).

(3) Forward earnings. As noted above, forward earnings tends to be a very good leading indicator of actual S&P 500 operating earnings over the next four quarters, as long as both are based on data compiled by Thomson Reuters (Fig. 7). Even so, this statement is only true when the economy is growing. Industry analysts, like economists, aren’t good at anticipating recessions. When economic downturns happen from time to time, everyone scrambles to cut their estimates.

Furthermore, during recessions Standard & Poor’s earnings data tend to be weaker than Thomson Reuters’ numbers because the former is closer to GAAP, while the latter is based on “majority rules,” as we discussed yesterday. In other words, forward earnings is even a worse predictor of GAAP earnings during recessions (Fig. 8). (See our S&P 500 vs. Thomson Reuters Earnings.)

In any event, forward earnings has been virtually flat in record-high territory since late 2014. It has edged lower over the past 24 weeks, as Joe reports below. The flattening has been all attributable to the renewed plunge in the forward earnings of the S&P 500 Energy sector (Fig. 9). Joe uses aggregate forward earnings rather than per-share data to show that. He also observes that excluding Energy, forward aggregate earnings has flattened out since mid-2014. (See our S&P 500 Excluding Energy.)

(4) Sectors. On a per-share basis, the forward earnings of the S&P 500 Energy sector has collapsed by 80.7% since July 2014 (Fig. 10). The more recent flattening of forward earnings excluding this sector is fairly widespread among the other nine sectors (Fig. 11). Actually, Materials has gotten weaker since the fall of last year after flat-lining since late 2010. Financials has been hard hit recently by the volatility in the equity and credit markets as well as the flattening of the yield curve.

(5) The dollar. Also weighing on many of the S&P 500’s sectors is the strong dollar. There is an inverse correlation between the yearly percent change in the trade-weighted dollar and the yearly percent change in S&P 500 forward earnings (Fig. 12). That’s not surprising since roughly half of S&P 500 revenues and earnings are from abroad. The dollar is up 7.5% y/y. On this basis, its relative momentum peaked at 15.7% on August 21. Nevertheless, it is up 21% since July 1, 2014, which remains a negative for profits.

Strategy II: Revenues & Margins. Yesterday, we reviewed the latest earnings figures for Q4-2015, comparing the data compiled by Thomson Reuters and Standard & Poor’s. Today, let’s have a look at the quarter’s revenues and profit margin results. When we do so, we find that the profits problem is due to both the weakness in revenues growth as well as the drop in the profit margin, both of which are mostly attributable to the Energy and Materials sectors. More specifically:

(1) Revenues. Fortunately, there’s no reason to adjust the revenues data so there is only one series, which is compiled by S&P. S&P 500 revenues rose last quarter for the third quarter in a row after falling sharply during Q1-2015, led by the drop in Energy revenues (Fig. 13). Nevertheless, revenues were down 3.9% y/y last year, though they edged up 0.4% excluding Energy (Fig. 14).

(2) Margins. As we noted yesterday, the S&P 500 quarterly profit margin has dropped from a record high of 10.7% during Q2-2015 to 10.2% at the end of last year using Thomson Reuters data for earnings (majority rules) (Fig. 15). It is down much more using S&P earnings data (GAAP rules) from a record high of 10.1% during Q3-2014 to 8.1% last quarter.

(3) Sectors. We can disaggregate the S&P data for the 10 sectors of the S&P 500. First, let’s look at the sectors’ revenues per share on a y/y basis through last quarter (Fig. 16): Consumer Discretionary (7.0% to a new record high), Consumer Staples (-2.1), Energy (-35.5%), Financials (1.7), Health Care (11.6 to a new record high), Industrials (0.3 to a new record high), Information Technology (-3.9), Materials (-10.5), Telecom Services (3.4), and Utilities (-9.5). Other than Energy and Materials, there are few signs of a revenues recession in the other sectors.

Now using S&P earnings data, which were especially depressed for Energy and Materials (more so than shown by Thomson Reuters data), we see that the steep declines in the margins for Energy and Materials last year account for the weakness in the S&P 500 margin, as calculated with S&P earnings data (Fig. 17).