You have seen the headlines - stocks are at all-time
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
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
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
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
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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
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
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
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 provide a context for the above consensus growth expectations,
chart 3 shows the absolute dollar levels of total quarterly and
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
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
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
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Sheraz Mian is the Director of Research for Zacks and
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