Today we’re going to dig into the state of corporate earnings, but before we do, consider this.
For the last however many decades, investors have generally turned to stocks for capital appreciation, and bonds for income. Has this dynamic reversed? Think about it for a moment.
Currently, over $7 trillion worth of sovereign bonds trading at negative yields. That doesn’t translate into very much income. Why would investors own negative yielding bonds? They’re either trying to make a profit from capital appreciation (bond prices continuing to rise and yields drop further below zero), or they’re pretty confident they’ll lose more money elsewhere.
And lately, utilities and telecom companies have been outperforming the broader market as a result of the stable dividends they pay.
Is it possible, as some are suggesting, that the dynamic has shifted? Are stocks the new income vehicle and bonds the new play on capital appreciation?
Just some food for thought.
Now onto earnings. As the ultimate driver of stock prices, earnings for S&P 500 companies are showing some conflicting and distressing signals.
As of last week, 87% of S&P 500 companies had reported, and preliminary estimates suggest Q4 will see revenues decline -3.7% and earnings declined -3.6%.
This probably doesn’t come as a surprise, considering how much attention the energy and materials sectors have received lately. The energy sector is currently showing Q4 revenue declines of -35% while earnings are on track to fall -74%. The materials sector is following suit, with revenues projected to have declined -15% and earnings -20%.
The immensely negative contribution of energy companies is causing some investors to focus on ex-energy figures. If we exclude the energy sectors, S&P 500 earnings are on track to rise 2.5%. Sounds good right?
While this might be encouraging, ignoring energy could provide a misguided view of the larger picture.
Take a look at the blue line in the chart below. It shows the trailing 12-month earnings-per-share for the S&P 500. Notice that EPS peaked in the second half of 2014. For those who can recall, that’s about when the dollar began to spread its wings. More on this in a moment.
The green line in the chart shows the S&P 500 price. You can see that the S&P 500 is highly correlated with EPS, which makes sense.
I want to draw your attention to one interesting part of the chart above. Take a look at the major pullback we experienced during 2011. This turned out to be a growth scare instead of a recession. As the green line (price) collapsed, look at what happened to EPS … it kept on rising.
This divergence led to a strong rebound in the market, as stocks eventually had to catch up with rising earnings-per-share. Unfortunately, what we’re seeing, this time, is different.
This time around, the drop in stocks is accurately reflecting the decline in EPS. To make matters a bit worse, earnings-per-share is also receiving a tailwind from corporate buybacks, which are at record levels. In theory, companies buying back their stock should see EPS rise, even if earnings are flat. This suggests that there may be more problems with the EPS figures than initially meet the eye.
Moving on, not only are we seeing overall earnings decline, we’re seeing the multiple that investors are willing to pay for each dollar of earnings collapse as well.
In the chart below, you can see the Trailing 12-Month PE ratio falling from just over 18 last year to under 17 currently.
These two trends, declining earning, and a declining price-to-earnings ratio, are a toxic combination for investors. They represent the worst of both worlds.
The question is, will these trends continue? Or will they reverse course in the coming months?
To answer that, we need to turn to the root cause for much of the earnings pain: the super-strong dollar.
The bleak reality is that over the last year and a half, our currency has been going to the gym religiously, lifting heavy weights, and has become incredibly strong. Our bodybuilder of a currency continues to cause undue pain for international companies.
Consider this analysis from FactSet. They compared earnings for companies that generate most (>50%) of their revenue from sales inside the US to companies that generate most of their sales outside the US
Companies that derive most of their revenue inside the US are on track to see earnings grow 2.7%.
Companies that derive most of their revenue outside the US are on track to see earnings fall -11.2%.
So when it comes to earnings, perhaps the real question is, where will the dollar head from here?
John Canally, chief economic strategist for LPL Financial, argues that the dollar headwind may slowly be abating and could turn into a tailwind. He uses the table below as evidence.
I’m a bit less optimistic. While the growth rate of the dollar is slowing, the value of the dollar remains elevated when compared to other currencies. For me this is akin to a retailer saying, “We’ve stopped raising our prices.” That doesn’t mean that prices aren’t incredibly high already.
Another comparison could be made to the Fed’s quantitative easing program. The Fed has stopped adding to its stockpile of Treasury securities, but this doesn’t mean that its massive balance sheet (abstracting supply from the market) isn't still continuing to work in favor of higher bond prices and lower yields.
Related: Will the US Go Negative in 2017?
Yes, it’s a good thing that the dollar seems to be stabilizing, but its current strength still puts international companies at a disadvantage when compared to the environment that existed over the past decade.
What would really be nice is if the dollar entered a prolonged downward trend. If this were to happen, however, there’s a good chance the weakening dollar would reflect deteriorating economic conditions at home, which itself would pose a headwind for earnings and growth. (The alternative scenario for a weakening dollar would include dramatic improvement in overseas conditions … unlikely at this point.)
My best guess is that the dollar will settle in near current levels and that means it will remain difficult for international companies to ramp up their sales and earnings, absent improving global demand. Analysts are more optimistic about earnings in the back half of the year, but we know to always take their optimism with a grain of salt.
The preceding content was an excerpt from Dow Theory Letters. To receive their daily updates and research, click here to subscribe.
About Matthew Kerkhoff
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