Tuesday, February 24, 2015

Identifying The Correct Risk Associated With Weak Earnings

Even casual observers of the equity markets know that there is always a multitude of risks which threaten the advance of stock prices. It takes little effort to identify these. Focusing on the correct risk is trickier part.

Let's take corporate earnings as an example.

The French bank Societe Generale (SocGen) is warning clients that weak earnings is a leading indicator that the US economy is headed into an imminent recession. Here's their chart (EPS growth in red and GDP growth in blue).

We don't believe this analysis will prove accurate, for several reasons.

First SocGen has been making this same argument for many years: in 2011 (read) and 2013 (read), to name just two. Their accuracy has been horrific.

Second, SPX company revenues grew 3.9% (TTM) in 4Q14, an increase from 2.4% in 4Q13. EPS grew 8.0%, an increase from 7.3% the year before. Neither is even close to being negative; both, in fact, have accelerated.

Third, it is true that analysts expect both revenues and EPS to decelerate this year. The 4Q14 financial reporting season is nearly over and analysts expect SPX company revenues to decline 3.3% (TTM) in 2015 while EPS to grow just 1.9%.  But the entirety of the deceleration in growth is due to energy which is expected to see EPS fall in half (chart from FactSet).

It would be a fairly unique recession if discretionary EPS were to grow more than 10%. More likely, SocGen are guilty of equating a decline in oil prices to a decline in overall demand.

To illustrate that point, note that retail sales, which decelerate into an oncoming recession, grew at the fastest pace in more than 4 years last month (chart from Calculated Risk).

That matters because retail sales correlate strongly with equity prices. There is a tight fundamental and logical relationship between overall demand and equity prices.

In short, an imminent recession is probably not the primary risk for US equities at the moment. That's significant because most bear markets are associated with a recession.

That is not to say that slow EPS growth poses zero risk to equity price appreciation. It does.

Scott Krisiloff of Avondale Asset Management looked at every instance since 1900 where EPS growth was weak and discovered that SPX rose anyway about 60% of the time. Read Scott's excellent post here.

However, in most of those cases, SPX had declined the year before and was trading at a modest valuation multiple. In other words, the market had discounted weak earnings growth the year before and it was reflected in premiums.

There were, in fact, just two cases (4% of instances) in the past 115 years like today where (1) EPS growth was weak, (2) SPX had risen strongly the year before, (3) valuations were steep and (4) SPX rose anyway (1997 and 1998).

SPX is currently trading at 18x earnings and 1.8x sales (TTM). Both of these are at least a 10% premium to historical means. Could SPX rise strongly this year anyway? Yes, it has happened before, but it has been the rare exception. More likely, 2015 turns out to be the year equity price appreciation takes a breather while corporate earnings catches up.

There are always a multitude of risks facing equity markets. At this moment, the risk of an economic recession and an associated 20-50% fall in equity prices is small (but not zero).  A year where equities chop and churn, dropping 10% and recovering, ending the year near where they started, is more likely to fit the historical pattern.

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