Wednesday, September 28, 2016

Persistent Profits Recession?

The Q3 earnings season starts early next month. There is already some chatter about the profits recession persisting for the sixth quarter in a row. I am in the camp that believes that it ended during Q2 and comparisons should turn positive during the second half of this year into next year. Let’s see what I may or may not be missing:

(1) Profits recession: A bottom? The 9/25 WSJ featured an article on this subject titled “Profit Slump for S&P 500 Heads for a Sixth Straight Quarter.” According to the story: “The third quarter was supposed to be when earnings growth returned to U.S. companies. Not anymore. Companies in the S&P 500 are now expected to report an earnings decline for the sixth consecutive quarter in the coming weeks, according to analysts polled by FactSet. That slump would be the longest since FactSet began tracking the data in 2008.”

I use S&P 500 actual operating earnings and analysts’ consensus operating earnings expectations data compiled by Thomson Reuters. On a year-over-year basis, earnings have been falling for the past four quarters through Q2-2016. Earnings are down 2.9% since they peaked in Q4-2014. However, the most recent low in this series occurred during Q1 of this year when earnings were down 11.7%, suggesting that might have been the bottom of the recession, though the y/y comparisons remained negative through Q2.

(2) Revenues: An upturn? My optimistic spin on earnings is supported by S&P 500 revenues, which declined on a y/y basis from Q1-2015 through Q4-2015. However, the actual level of revenues admittedly has been volatile in a flat range (though near recent record-high territory) since mid-2014, when the price of oil started to plunge.

(3) Analysts’ consensus: Another hook? The Thomson Reuters data confirms the WSJ story, which is based on FactSet data. The Q3 consensus estimate turned negative on a y/y basis recently, and was -0.8% last week. However, as I have noted going into every earnings season since the start of the bull market, actual results often tend to exceed downwardly revised estimates just before the earnings season begins. Let’s call it the “earnings hockey stick.” The average hook in the stick since Q2-2009 through Q2-2016 has been 4.8%. There wasn’t one quarter over this period with a negative surprise.

The positive surprise for Q2-2016 was 3.6%. It won’t take that much of a positive surprise to produce a positive y/y comparison for Q3-2016.

(4) Forward earnings: What really matters. I believe that the stock market discounts forward earnings, i.e., the S&P 500 12-month forward consensus expected operating earnings. It is a time-weighted average of analysts’ earnings estimates for this year and next year, and is usually a good year-ahead leading indicator of actual earnings. When the earnings season starts in October, forward earnings will give a weight of only 3/12 to this year’s estimate and 9/12 to next year’s estimate.

Doing this calculation using weekly data shows that the S&P 500 forward earnings has rebounded nicely since the spring of this year and is back at $129.20 per share, near the record highs of 2014. That’s because it is converging to the current estimate of $133.57 for 2017. I just added 2018 consensus estimates to our numerous earnings charts. Analysts are currently predicting $147.49 per share for 2018. While those numbers are bound to be revised downward over time, as typically occurs, there’s certainly no profits recession in the analysts’ earnings outlook for the next couple of years.

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