ENTERING THE DARK SIDE

The Q3 earnings season is now behind us. S&P calculates the beat rate at 66% and the miss rate at 23%. However, only Health Care (73%) and IT (83%) truly beat the average. In fact, 7 of the 10 S&P sectors came in below the average beat rate. Excluding Health Care and IT, the beat rate is 62% and the miss rate is 27%. On that basis, the Q3’13 earnings season looks rather uninspiring.

Factset suggests that companies have nearly exhausted their ability to surprise us:

In aggregate, companies are reporting earnings that are 1.7% above expectations. Over the last four quarters on average, actual earnings have surpassed estimates by 3.7%. Over the past four years on average, actual earnings have surpassed estimates by 6.5%.

imageBut overall results are in fact pretty good. Quarterly earnings totalled $26.86, up 11.9% YoY, which brought trailing 12- month EPS to $102.14, finally breaking the $$98-99 range of the previous 6 quarters.

Revenues grew 4.2% YoY while margins rose from 8.92% in Q3’12 to 9.58% last quarter, just shy of the Q3’06 record of 9.60%, thanks primarily to large jumps in margins at Financials (+2.7%), IT (+1.8%), Telecoms (+1.4%) and Utilities (+1.2%). Notice that the more economy-sensitive sectors did not enjoy higher margins last quarter.

Q4 estimates are now $28.08, a 21% YoY increase against a quarter which included charges related to unfunded pension liabilities. Estimates continue to trickle down but at a very slow pace, even after the end of the Q3 season and all the conference calls. Yet, Factset warns that

(…) 101 companies in the index have issued EPS guidance for the fourth quarter. Of these 101 companies, 89 have issued negative EPS guidance and 12 have issued positive EPS guidance. Thus, the percentage of companies issuing negative EPS guidance to date for the fourth quarter is 88%. This percentage is well above the 5-year average of 63%.

One of the reasons for the high percentage of negative EPS guidance is the unusually low number of companies issuing positive EPS guidance. Over the past four quarters (Q412 – Q313), 86 companies on average have issued negative EPS guidance and 26 companies on average have issued positive EPS guidance. Thus, the number of companies issuing negative EPS guidance for Q4 is up only 3% compared to the one-year average, while the number of companies issuing positive EPS guidance for Q4 is down 54% compared to the one-year average.

While 20% of S&P 500 companies have issued negative guidance for Q4, that ratio jumps to 38% for IT and 24% for Consumer Discretionary companies.

This corporate cautiousness has not (yet) transpired into more cautious analyst estimates. In fact, analysts continue to forecast sharply rising margins throughout 2014 as this Factset chart reveals:

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Morgan Stanley illustrates the apparent exuberance with this chart (via ZeroHedge):

Is this realistic or pure wishful thinking?

Thomson Reuters provides useful insight in this debate (my emphasis):

(…) looking at growth in net income shows the increase in the profits of a company as a whole, which is not affected by share repurchases. The difference between EPS growth and net income growth is the result of changing share counts. For the third quarter, net income growth for the S&P 500 is 3.5%, more than two percentage points below the EPS growth rate of 5.7%, meaning that declining share counts have boosted earnings growth. As Exhibit 1 shows, lower share counts have boosted earnings per share growth in the index as a whole, and in each sector except for utilities.

Exhibit 1. S&P 500 Q3 2013 Growth Estimates: Net Income and Share-Weighted Earnings
ER_1125_chart1
Source: Thomson Reuters I/B/E/S

Exhibit 2 depicts the components of share-weighted earnings growth. The revenue growth component shows what portion of earnings growth is due to top-line growth of the business, assuming constant profit margins. The benefit from share repurchases, discussed above, represents the part of earnings growth due to changes in share count. The remainder, other factors, includes any other reasons for higher earnings growth, such as operating leverage, efficiency improvements and cost-cutting.

For the third quarter, this segment is small, with only 0.3% coming from other factors, meaning that the 5.7% earnings growth is primarily due to top-line growth and share repurchases, with minimal help from cost-cutting.

Exhibit 2. S&P 500 Components of Earnings per Share Growth

ER_1125_chart2Source: Thomson Reuters I/B/E/S

Looking ahead to Q4, analysts expect revenue growth of only 0.6%, while earnings are expected to increase 8.1%. With a 1.9% expected boost from share repurchases, current earnings estimates are implying large increases in other factors. This means that companies are either going to realize far more efficiencies than they did this quarter, or that current earnings estimates are too optimistic.

Margins don’t simply fluctuate randomly. Scotia Capital uses capacity utilization as a proxy for corporate margins. This sure get the trends right but margins have recently exceeded the level suggested by capacity utilization, most likely due to labour cost controls.

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SoGen’s Albert Edwards has another sensible approach, plotting unit labour costs against corporate output prices, a proxy for selling prices, which suggests that the tight labour cost control era is near its end and that margins are currently getting pressured by slow revenue growth, validating Thomson Reuters’ earlier comments (chart via ZeroHedge):

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Zacks Research shows that Q4’13 downward estimates revisions have in fact accelerated lately.

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Using S&P data, trailing 4Q EPS should grow from their current $102.14 to $107.07 after Q4’14, a 4.8% QoQ improvement and an acceleration from the 2.9% gain after Q3’13. The margins risk lies mainly with 2014 estimates when analysts are forecasting margins rising a large 0.9% to a record 10.4% by Q4’14.

Such a rise in such a short period would be truly outstanding and I would not bet on it. Neither, however, would I want to bet on a meaningful decline in margins as many bears are loudly suggesting based on the irresistible mean-reversion phenomenon. I have posted last June on profit margins (Margins Calls Can Be Ruinous In Many Ways), warning that avoiding equities on the basis of an expected collapse in margins was not sensible in the current environment.

In brief, arguing that margins are historically high and assuming they will necessarily mean revert appear to be too simplistic analysis, at least until we begin to see a real trend toward tax rates normalization across the world.

The reality is that the S&P 500 is no longer a direct reflection of the U.S. economy but rather a global index. Currently, 45% of its revenues are recorded abroad, a proportion that has been rising over time. Foreign revenues seem to attract higher margins and one of the main reasons for that is lower foreign tax rates.

Warren Buffett’s 6% peak margin may be an appropriate benchmark for domestic profits but American corporations have shifted a meaningful part of their profits to lower tax jurisdictions in the past 2 decades. ISI calculates that there are 135 S&P companies where the foreign effective tax rate was less than 20% in 2012 (52% of which were in the Tech and Health Care sectors) and that the effective tax rate on the foreign earnings of S&P 500 companies was 25% in 2012, down significantly from 29% in 2008 and substantially lower than the 35% U.S. statutory rate.

Unsurprisingly, Heath Care and IT companies enjoy the lowest foreign tax rates. According to ISI, these two sectors have seen their foreign tax rate drop from 21% to 12% for Health Care and from 28% to 10% for IT since 2003. These two sectors account for nearly 33% of the S&P 500 capitalization, up from 13% twenty years ago, greatly contributing to the rise in aggregate S&P 500 profit margins. Will foreign margins mean-revert anytime soon?

On November 19, Senate Finance Committee Chairman Max Baucus tabled a proposal to overhaul the U.S. tax system.

The LIFT America Coalition, which includes major technology, pharmaceutical and consumer-products firms, termed some aspects “punitive against globally engaged American headquartered companies.”

Other U.S. firms, particularly those with a domestic focus that worry more about the high U.S. corporate-tax rate, cheered the proposal as a needed step. The RATE Coalition, which includes major retail, defense and telecommunications firms, said “we welcome a process that leads toward…comprehensive tax reform that will encourage economic growth and create jobs for American workers.”

The “LIFT RATE” (!) coalitions not seeing eye to eye on this major issue, it seems highly unlikely that anything major will be done in 2014, at the earliest.

The Baucus plan would impose a temporary corporate tax on that money at a rate of up to 20%, below the current 35% top rate. That would raise more than $200 billion for the government. Next, the plan would begin moving the U.S. to a system that would no longer seek to impose U.S. tax on some types of overseas income. That would put the U.S. closer to the mainstream of developed nations.

The back-and-forth underscored how tricky it will be to reach consensus even among big businesses on overhauling the U.S. tax system. Domestic firms care more about the posted corporate-tax rate while multinationals care more about what the world-wide tax system would look like. (WSJ)

So, don’t hold your breadth! And don’t expect a substantial decline in profit margins any time soon, unless the U.S. economy enters in recession (chart below from Doug Short). Given the Fed’s determination to keep the financial heroin flowing and the absence of any significant warning signs of an approaching recession, it seems sensible to stay cool on profit margins for a while longer.

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The Rule of 20 suggests that fair value on the S&P 500 Index is 1869, a mere 3% above current levels. Since 1956, the Rule of 20 P/E (actual P/E + inflation) has gone through the 20 fair value level 9 out of the 13 times it rose to “20”. Another way to look at it is to say that every time the Rule of 20 P/E rose to “20”, it kept rising into the “higher risk” area except between 1963 and 1966 and since 2009.

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Between 1963 and 1966, equity markets rose in sync with earnings while inflation remained stuck between 1% and 2%. Equities subsequently quickly lost 17% when inflation spiked from 2% to 3.6% in less than 9 months.

Since 2009, traumatized investors refused to get carried away, nervous and uncertain as they were about the world economy, U.S. politics and Fed behaviour, all these fears being amplified by generally negative media narratives.

Little has really changed other than the capitulation of most of the bears as the most recent equity rally silenced most of them and revived greed instincts supposedly extinct forever after the financial crisis. The last 55 years history suggests that the odds that equities will soon trade through fair value into the “rising risk” (yellow) area are 69% (9/13). A rise to the yellow-red boundary (Rule of 20 P/E of 22) would take the S&P 500 Index to 2070 (trailing EPS of $102 and inflation of 1.7%= P/E of 20.3), 14% above current levels. If trailing EPS reach $107 by March 2014, fair value would rise to 2172, 20% higher than the current 8010 level.

The downside can be assessed in two ways:

  1. Investor confidence disappears for some reason and the Rule of 20 P/E drops to the 16-17 lows seen in the past 4 years. The S&P 500 Index could thus drop 15-20% to the 1500 range.
  2. Markets simply “technically correct” to either their 100-day moving average (-5.5% to 1710) or their 200-day m.a. (-8.8% to 1650). The former light correction occurred in June, August and October 2013. The latter more brutal correction was experienced in November and December 2012. Importantly, both moving averages are still rising smartly, implying that this technical downside risk diminishes with time.

The best that could happen is a repeat of the 1963-66 ride along fair value. Earnings would keep rising but the remaining mean-reverters and Shiller P/E fans (The Shiller P/E: Alas, A Useless Friend) would keep fear high enough to prevent equity markets from getting overvalued.

In all, this is the objective, measured and dispassionate risk/reward lay of the land:

  • Current fair value is 1869, only 3% above current levels. By March, assuming inflation stays at 1.7%, rising trailing earnings would boost fair value to 1960, 8% above current levels.
  • With 70% odds of equities selling through fair value, upside rises to 2070-2172 by March, +14-20% or 10-14% risk-adjusted.
  • Technical downside is 5-10% but resumption of fear could set us back 15-20%.

Equity investors are about to enter the dark side where the tilt is gradually getting unbalanced towards higher risk. The Force, energized by greed instincts and the Fed’s ZIRP, will suck increasingly hard at the Jedi within each of us. The latest II survey shows the extent of the decimation of the Ursid specie by the bulls. Bears may not be the most popular but, when in sufficient quantity, they serve to keep us away from the dark side. Beware Luke Skywalker, you could lose your hand, even worse, an arm and a leg.

 

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