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What is the Stock Market's Achilles Heel?

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You have seen the headlines - stocks are at all-time highs.

Reasonable people can disagree over what matters more to the stock market, but no one can deny the centrality of earnings to stocks. Some even go to the extent of calling earnings the 'mother's milk' of stock prices.

So, if stocks are doing this good, then earnings must be in very good shape. But are they?

My answer is: No. The market is pricing a view of earnings that is unlikely to play out. This, in my judgment, is the weakest link in the current positive narrative driving the stock market rally.

Earnings growth has been essentially non-existent over the last few quarters, a trend that consensus expectations see persisting through 2013 Q2. But growth is expected to come roaring back in the second half of the year and continue into 2014.

I don't think it's going to pan out like this and want to share the basis for my skepticism with you in this write-up. I am by no means suggesting an earnings train wreck or a call to exit the market altogether. What I am suggesting instead is that current earnings expectations are vulnerable to significant downward revisions. And an acceleration in that negative revisions process will most likely result in the market giving back some, if not all, of its recent gains.

You don't have to agree with my conclusions. But it would nevertheless pay to be a little skeptical of current earnings expectations, take another look at your portfolio and perhaps reposition it for an extended period of weakness. The discussion is particularly timely with the 2013 Q1 earnings season giving investors a misleading sense of security about the earnings picture.

My goal in this write-up is to give you an update on how the Q1 earnings season turned out and what we can say about the coming periods.

More . . .


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Was the Q1 Earnings Season That Good?

By most conventional measures, the Q1 earnings season turned out to be 'average' or 'below average'; it certainly wasn't good.

Total earnings for the 465 S&P 500 companies that have reported Q1 results as of Friday, May 17th are up +2.8% year over year with 65.4% of the companies beating earnings expectations. Total revenues are down -1% with only 41.5% of companies beating top-line expectations.

When we compare the Q1 results to the last few quarters we find that the earnings growth rate is roughly comparable even though it's somewhat lower. But it's hard to gloss over the revenue underperformance.

Chart 1 - Earnings & Revenue Growth Rates Compared

Note: The data compares the growth rates for the 465 companies that have reported results with performance of the same in the preceding quarters. Revenue in Q4 got a one-off boost from gains at Prudential Financial (PRU). Excluding the Prudential revenue, total revenue growth would be +2.6% in Q4. The 'average' is the 4-quarter average.

Expectations for the Coming Quarters

Analysts have been cutting their estimates for Q2 ever since the Q1 earnings season got underway, with the predominantly negative tone of company guidance as the primary driver.

Chart 2 below provides the expected earnings growth rates and what we got in the preceding quarter and year.

Chart 2 - Expected Earnings Growth Rates

Note: The reason for the variance between the growth rate for 2013 Q1 in chart 2 vs. chart 1 is that chart 2 is presenting the composite growth rate for Q1, meaning a blend of the 465 companies that have reported already with the 35 still to come.

To provide a context for the above consensus growth expectations, chart 3 shows the absolute dollar levels of total quarterly and annual earnings.

Chart 3 - Total Quarterly and Annual Earnings

What we see here is that total earnings are already at an all-time record level in Q1, but they are expected to go even higher in the last two quarters of the year.

In essence, consensus expectations are for a very strong +9.6% growth in the second half of 2013 after a much more modest +1.7% gain in the first half. This growth momentum is then expected to carry into 2014, giving us earnings growth of +11.4% that year after the +6.1% gain in 2013 and +3.4% growth in 2012.

How Realistic Are These Expectations?

I don't think these expectations will pan out. And here is why.

Earnings can grow only through two ways - revenue growth and/or margin expansion - and the outlook on both fronts is problematic. Margins have peaked already and at best can be expected to remain stable around current levels. And you can't have significant revenue gains in the current constrained economic growth environment.

The U.S. economy is in somewhat better shape relative to the recession in Europe and Japan's efforts to inflate away its problems. But that's only in relative terms - the reality is that the U.S. economy is at best on a sub-2% growth trajectory. And even that growth pace may be at risk from the unfolding fiscal austerity. Hard to envision companies reversing the revenue growth problems in the coming quarters.

Margins follow a cyclical pattern. They expand as the economy comes out of a recession, then stabilize, and eventually start coming down as capacity constraints force spending more for incremental business. I don't agree with those that are looking for margins to start contracting, but I can't see margins expanding either.

So What Gives?

Not only are margins already at record levels, but corporate earnings as a share of GDP are also at multi-decade highs. Just like trees don't grow to the skies, margins and the ratio of earnings to GDP don't expand forever either.

What all of this boils down to is that current earnings estimates are high and they need to come down - and come down quite a bit. One could reasonably draw a scenario where earnings growth could turn negative this year. But the most likely path appears to be for earnings growth to flatten out - with the absolute level of earnings this year and next not much different from what we got in 2012.

How Do You Invest in this Environment?

The way to invest in such an environment is to look for stocks that don't reflect aggressive growth expectations and enjoy company-specific growth drivers not tied to broader macro trends. Companies that generate plenty of cash flows beyond their immediate capital needs and have track records of sharing excess cash with shareholders through dividends and buybacks are particularly well suited for a period of sub-par earnings growth environment. Bottom line, look for thematic stocks with strong defensive attributes.

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Sheraz Mian

Sheraz Mian is the Director of Research for Zacks and manages our award-winning Focus List portfolio. He names three key investment opportunities in the latest edition of Zacks Confidential.


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