Earnings Suggest Recession

from Marketwatch today:

Stocks Hit by Weak Alcoa Earnings

Earnings Season Off in Earnest

Even Goldman tops estimates, but has lower earnings. That seems contradictory, but not when lower earnings guidance is baked into the cake.

Stock Returns Historically Weak On HIgh Earnings Expectations

from Bill Hester at Hussman Funds:

This week brings the official start to second-quarter earnings announcements. As the mechanism for data delivery gets switched from the faucet to the fire hose, investors may want to keep a few things in mind as the reporting season progresses. Lofty earnings expectations result in poor stock market performance, on average. Forecasts for expected earnings are typically the most misleading at economic inflection points. And less frequent and less celebrated data such as the Purchasing Managers Indexes may provide a better view of future profits than analyst's expectations. The diverging trend between the PMI data and earnings expectations will be important to watch.

The chart below gives one perspective into how bullish stock analysts currently are. The data is compiled by Ned Davis and it shows the median estimated one-year earnings growth rate for the companies in the S&P 500. Analysts are now forecasting more than 21 percent earnings growth for the median stock over the next year, a record level in the 30 years of data.

As Ned Davis has noted, stock returns are usually considerably weaker beginning from periods with high earnings expectations. The stock market has risen 18 percent on an annualized basis when earnings expectations are below 5 percent. When expectations rise above 15 percent, annualized total returns fall to -12 percent. Stocks are more vulnerable when robust earnings growth is already assumed by investors.

Projected earnings growth by Wall Street analysts is also far less "forward looking" than one might imagine. The graph below plots the median expected 12-month forward growth rate expected by analysts, along with the percentage change in actual S&P 500 earnings per share over the preceding year. At each point on the graph, the growth rate that analysts expect for earnings over the next year is plotted with the actual change in earnings over the prior year. The graph shows that they shadow each other closely. This suggests that forecasted earnings for the next year are little more than an extrapolation of the change in earnings over the prior year. The correlation between year-ahead earnings growth expectations and the actual growth in earnings over the same period is .28 (statistically, this means that Wall Street's forecasts explain less than one-tenth of the variation in actual earnings growth over the following year). The correlation between year-ahead growth expectations and the change in earnings over the prior year is .75.

Analysts are heavily influenced by recent earnings performance. So it's not surprising to see the current high earnings expectations considering the strong rebound in S&P 500 earnings over the past year. But, in a year's time, the record suggests they'll likely be wide off the mark.

A more valuable indicator of future profits may be the ISM's manufacturing report. Even though manufacturing represents a declining share of economic output, it continues to be responsible for the some of the most volatile components of GDP – and corporate profits. The graph below compares the level of the PMI Index and the year-over-year changes in S&P 500 Index earnings shifted forward by six months (the blue line).

It's this correlation between manufacturing indexes and profits that can partly explain the weakness in the global markets during the last two months. That's because the US Purchasing Managers Index is not alone in looking as if it is rolling over. Of the G7 countries, 5 domestic PMI indexes fell last month. Germany's index was unchanged and Italy's rose marginally. China, Taiwan, Singapore, and India metrics have also fallen in recent data. While these indexes still sit above 50, indicating expansion, the shared peak, mostly in April, and decline in their levels has investors worried.

Economists are responding to the softness in the leading indicators. In their most recent survey, economists told Bloomberg they expect the U.S. economy to grow 2.8 percent in the third quarter, down from 3 percent a month ago. At the same time, stock analysts have continued to increase their estimates for earnings growth.

The graph below attempts to contrast the erosion in the global PMI indexes against the rising optimism of stock analysts. Six series of data are plotted: the changes in earnings expected for the companies in the S&P 500 and the Euro Stoxx Index, and four PMI indexes for the US, the Euro area, Germany, and China. Each of the series is indexed to 100 in April, the month where most of the PMI data peaked.

The chart shows the growing divergence between expectations for earnings and the global PMI indexes. These indexes will be important to watch over the next couple of months. As John Hussman noted in Recession Warning , three of the four metrics that provided a warning of an approaching recession in 2007 are in place. A drop in the PMI index to 54 or below is the remaining indicator in that original set of metrics that hasn't signaled. But the weakness in the growth rate of ECRI's Weekly Leading Index – which leads the PMI by about three months – when combined with the other indicators are currently enough to expect a period of renewed weakness.

Therefore there are two dynamics that are now in place that were also in place near the end of 2007. Global earnings expectations are climbing while global PMI indexes are declining and there is sufficient evidence in hand to be concerned about a period of renewed weakness in the U.S. economy. The graph below shows the period between 2007 and 2008 using the same indices (leaving out China in this case because its economy peaked in 2008). It shows the same divergence in earnings expectations and PMI indexes along with when the recession signal was given in 2007.

The spread between the changes in global PMI Indexes and global earnings expectations is an increasing concern, especially considering the evidence that increases the probability of renewed economic weakness. Earnings growth forecasts have never been higher measured by the median expectation. This alone, typically leads to poor stock performance. The growing gap between PMI Indexes and earnings expectations increases these potential risks.

Q1 Earnings Not Such a Pretty Picture After All

from Zero Hedge:

Posted by Tyler Durden at 9:47 AM

There's some excitement about all the companies that beat Q1 S&P earnings estimates (see first chart). However, once you consider how many beat revenue estimates, it's a less compelling picture. Companies are slashing expenses at a ferocious pace, which is an anorexic approach to profitability that cannot be sustained for long (same dynamic in places like France, where employment is falling at the fastest pace since 1970). A bounce in demand in H2 2009 will be critical in unleashing the operating leverage now being created; otherwise this is an Earnings Quality issue. The most vibrant activity appears in Asia, where recent import demand has been 3x higher than the developed world.

As for U.S. consumers, headwinds may still be under-appreciated. Notices of Default (which precede foreclosures) are surging, counter-cyclical municipal tax and spending policies will be widely felt, and issuance of new credit cards (closely tied to retail sales) are falling off a cliff. Perhaps that's why bank credit card losses are already running close to the Fed's Adverse Case. There's also the issue of "Income Quality". Households are seeing escalating contributions from government transfer payments, rather than earned income (2nd chart). It does not take an economics degree to consider these transfer payments ephemeral, and something that will have to be paid for one day. The current savings rates have a long upward march from here.

Earnings Normalized -- NOT!

from The Big Picture blog:

I am becoming terribly enamored of the charts Ron Griess highlights each week form The Chart Store. Now that earnings season is all but over, Ron looks at a few charts that are revealing of the extent of the damage done to corporate profitability. It is, in a word, breathtaking:>

How Cheap Are Stocks?

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How Much Have Profits Fallen?

It appears that we have learned nothing about risk from our past experience. We're going to have to learn the hard way!

More Big Bank Accounting Shenanigans

from Bloomberg:

Citigroup posted a $2.5 billion gain because of an accounting change adopted in 2007. Under the rule, companies are allowed to record any declines in the market value of their own debt as an unrealized gain.

Accounting Changes

The rule reflects the possibility that a company could buy back its own debt at a discount, which under traditional accounting methods would result in a profit. Critics say a company in distress is unlikely to realize the gains, and would have to reverse them eventually if it recovers.

Such reversals probably contributed to a first-quarter loss at New York-based Morgan Stanley, the Wall Street Journal reported April 8.

Citigroup, one of 19 U.S. banks gearing up for the release of “stress tests” run by the Federal Reserve, has quadrupled on the New York Stock Exchange since falling to an all-time low of $1.02 on March 5, in the wake of the company’s announcement that as much as $52.5 billion of preferred stock would be exchanged for common shares to bolster the bank’s equity base.

from NYT:

Goldman’s explanations sometimes do not ring true, even if they are. When it announced its profits this week, it buried an important fact in the tables on page 10 of a news release, and did not mention it in the text of the release. That fact was that Goldman had lost a lot of money in December, which would have been part of the quarter had the firm not changed its fiscal year. As a result, that loss does not show up in any quarterly number. Goldman won’t say if a December-to-February quarter would have been profitable.

Was Goldman’s disclosure misleading? Legally, no. There was full disclosure. But the existence of the orphan month, with its big loss, was largely overlooked in the initial news stories. When it was reported later, Goldman was left looking as if it had tried to pull a fast one.

Earnings from Banks May Bring Swift End to Stock Rally

from Bloomberg:
Investors are depending on banks more than at any time in at least 60 years to lead the U.S. out of the longest earnings slump since the Great Depression.

American companies will end more than two years of declining income by the fourth quarter, according to analyst forecasts compiled by Bloomberg. Banks will be responsible for all of the 76 percent rebound in the final three months of the year, because without financial companies, the gain turns into a 4.5 percent decline, the data show.

Rathbone Brothers Plc, MFS Investment Management and TD Ameritrade Holding Corp. say the reliance on banks is making them increasingly concerned that the 25 percent gain by the Standard & Poor’s 500 Index since March 9, the steepest rally since 1938, will dissipate. While rising home sales and durable- goods orders show the economy may be bottoming, unemployment and consumer debt as well as prospects that banks will be forced to write down more loans may halt the gain in equities.

Earnings (Disappointment) and Lay-Off Season

The Dow is down another 50 points at this writing, and both Eurozone and Asian stock markets are down almost across the board. (So are my beloved grain futures.)

David Calloway wrote this prescient editorial on Marketwatch:

"Everybody should have known the holidays would only delay it. The freight train of job cuts, plunging earnings and massive spending cutbacks set to hit the economy was, thankfully, pushed back a few weeks while stunned investors and workers across the globe caught their breath after the worst fourth quarter in decades.
"...Earnings season, the time for companies to 'fess up just how bad it's been for them in the last three months, is here."

Read his entire commentary here. He says now, "the great dying begins".

And now, the earnings disappointments begin. Yesterday, the stock market dipped when three Fortune 500 companies all issued earnings disappointments and reduced their earnings forecasts. Two also announced lay-offs. The three companies were from different industries, but seemed to bring a cold dose of reality to the optimistic sentiment of the past few weeks, especially since a few were from sectors that had previously thought to be resilient. Last night, Lenovo, a technology company, also issued dissapointing earnings news, throwing more cold water on the idea that technology stocks would escape the bloodshed and pain. They won't.

I have thought throughout this recession that eventually, investors would be disappointed, since in past recessions, technology purchases, representing discretionary spending for consumers, have always been hit hard. Tech stocks are not a safe haven from the dip in consumer spending.

And here is an article from Bloomberg today about the effect on stocks due to an expected onslought of earnings disappointments:

Stocks in Europe and Asia dropped, sending the MSCI World Index lower for a second day, on concern the deepening economic slump is wiping out earnings growth and demand for commodities. U.S. index futures declined.

Here is the entire story.