Earnings Inflection

Earnings season for Q3 2012 has been underwhelming. It appears as if the macro decay of the first half of the year is settling in at the corporate level. With about 20% of the S&P 500 companies reporting earnings so far, revenue growth has actually underperformed even the re-adjusted expectations from just last month.

Initial estimates of operating earnings for Q3 2012 from as late as December 2011, were as high as $28. Based on this first group of earnings reports, it appears as if operating earnings will be somewhere around $24.70 to $24.90 (12% below those initial estimates). In terms of reported earnings (not operating earnings), year over year growth is expected to be worse than Q2, meaning a larger decline in EPS for S&P 500 companies.

There is a real contrast with the 2003 recovery period coming out of the dot-com bust. After the initial burst of earnings growth off the cycle trough, earnings growth settled into a narrow but significantly positive range throughout the artificial housing “boom” period. That was consistent with slow but steady economic growth. Since the middle of 2010, however, earnings growth has steadily decelerated now to the point of negative growth; or as some term it, an earnings recession.

In the past two decades, earnings growth has been negative on only a handful of occasions.

On three occasions, the US fell into recession shortly thereafter. Of the other two instances in the mid-1990’s, recessions were avoided.

Clearly the two non-recessionary episodes in the 1990’s were less striking in market terms. No doubt some of the disparity is due to the raging bull market then reaching the mania phase. But even so, recessionary expectations may play a role in how markets perceive the severity of any earnings growth curtailment.

In the 1995 occurrence, there were some lingering doubts about the viability of the recovery to that point as the economic and financial systems were adjusting to the belated rate increases engineered by the Federal Reserve, but economic growth on the whole was not at all challenged as much as some feared given any interest rate change.

The 1997-98 incident, however, was related to the Asian flu that was sweeping the currency and credit markets. While it was a severe event in the financial system, it was largely constrained outside of the US domestic processes (LTCM and Fed overreaction aside). In domestic economic terms, there was little evidence of a slowdown in the growth trajectory. That was confirmed by the relatively short duration of the earnings setback.

A more complete explanation for market behavior surrounding earnings recession and economic recession might be explained by the coincidence of corporate default and bankruptcy. While earnings growth certainly plays a large factor in investor willingness to buy and hold equities, the flipside is fear and liquidity. Those two dynamics, that are very much interrelated, might help explain the more severe reactions in the recessionary environments (particularly in the bubble world after the mid-1990’s).

In the pre-recessionary environment of 2000, not only was the degree of the earnings trough much larger than in the two mid-1990’s episodes, it was parallel to an historic rise in the level of corporate defaults and bankruptcies. Credit usage since the early 1980’s had penetrated to a much larger degree than the historical norm, meaning that equity investors were much more exposed to the capital structure than anticipated. So the extreme valuations of that period against a backdrop of earnings and defaults was the recipe for a dramatic bear market.

The overall recession of 2001 was perhaps the mildest recession on record. It was largely contained to the business investment side of the economy as consumer spending barely registered any impediment. This suggests that the incidence or occurrence of recession is not the primary consideration driving market expectations, but the manifestation of how the recession interacts in economic sectors might be far more important. The size of the market’s decline was out of line with such a mild recessionary event until we factor in the then historically high default/bankruptcy rate against those irrationally exuberant valuations.

Crisis in the 2007-09 period really needs little explanation, particularly since it exhibited about every nasty economic and financial trend known to exist. High valuations again juxtaposed against historic defaults, bankruptcies, earnings collapse, liquidity and financial dysfunction, and real economy carnage. The stock market’s reaction to all of it almost seems understated by comparison of degree.

I think what is important to take away from all of this is that the interplay of all these factors are what ultimately drives market investors. Recessions by themselves do not necessarily produce market declines (2001) without coincident occurrences of earnings depression and fear driven by the potential for defaults. Along those lines, though the evidence here is far too narrowly construed and hardly dispositive, the current environment features all of the warning signs evident in the worst markets of the past two decades.

We currently have high valuations (a CAPE of about 23 is historically high), warning signs of impending recession, an existing earnings recession and the potential for historically high defaults. According to S&P, speculative grade default rates have risen since the middle of 2011 off the low of about 2% to more than 3%. In their expectations for 2013, S&P indicated default rates of about 4%, perhaps as high as 6%.

Those rates would put defaults back well above historic averages. Worse, despite ZIRP the interest burden on corporate America has never been higher at this point in a “recovery” cycle (such that one exists today). That indicates that corporations have been bulking up their balance sheets with, as Paul Krugman indicated, “free money”. The problem with so much “free money” and recessionary events is that “free money” eventually needs to be rolled. If conditions are not conducive toward easy refinancing then defaults pile up and equity investors have to begin to revisit their place in the capital structure.

As further earnings reports filter through for Q3, we need to keep in mind these various processes and how they might impact markets going forward. Inflection points are rarely points at all; they are a broad-based change in trends that work over time. Central banks have been, in my opinion, the main driving force behind the demand for equities, but fundamentals will eventually matter.  Given the market’s move in anticipation of QE this time rather than a reflex afterward I also have to question how much additional support markets might perceive. Even if there are any monetary bullets left for the FOMC, despite all the rhetoric, they cannot manufacture corporate earnings nor can they keep already weak firms from succumbing to the economic and debt reality created by distorted credit and risk prices. In this regard, even a mild recession could produce an outsized market reaction, particularly if the parallels to 2001 prove to be valid.  We don’t need to repeat 2008.

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