The Expectations Gap
The stock market had a good week, up all four trading days, despite the continued mixed picture from the economy and earnings. Last week’s economic reports continued the recent pattern of some seemingly strong reports mixed with some pretty obviously weak ones. Retail sales were better than expected but the year over year core growth rate is still at levels that are much less than desirable. Certainly auto sales have improved the last two months, something that appears to be weather related and that is a positive. But it is disconcerting that outside of autos and the low quality loans that fund them, spending just can’t seem to gain any traction. Inventories did improve a bit with sales exceeding the build but not enough to significantly impact the inventory/sales ratio.
The manufacturing reports out last week were near polar opposites. The Empire State report was barely positive and the new orders component remains in negative territory. By contrast, the Philly Fed report had a good jump with most every component rising strongly. I cannot explain how two areas of the country so close geographically could have such divergent reports but it is no different than we’ve seen for months now. The industrial production numbers would seem to support the Philly view with a rise of 0.7% and the manufacturing component up 0.5%. A drop in mortgage rates had a positive effect on applications with both purchase and refinance activity rising. On the other hand, the housing market index came in at 47, less than the 50 that denotes expansion with traffic the weakest part of the report at 32. That would seem to be a function of a lack of first time buyers who are constrained by low savings and income.
Housing appears to be peaking in price and activity at least for now. The cash institutional buyers have reduced their activity significantly as prices have risen too far to justify further investment in rental properties. That leaves real buyers in the market and higher prices and stagnant incomes appear to be limiting activity. Growth in permits and starts has stagnated since the middle of last year as mortgage originations have collapsed. It is construction that matters for overall economic growth and the demand just hasn’t been there recently.
Earnings season is underway and the picture there is every bit as mixed as with the general economy. Expectations for the quarter were reduced so much over the last few months that the consensus now sees a decline of 1.3% year over year for the full quarter. With 82 companies in the S&P 500 reporting so far 66% have reported above estimates while 50% have reported sales above estimates. Both of those are below the long term averages but there is a long way to go yet. There were some high profile misses such as Google and IBM which both took a hit after reporting. There were also some notable beats such as GE and JNJ. But the overall message seems to be one of weak sales and earnings growth.
What is concerning about the stock market as a whole is the gap that is – and has been – developing between expectations for earnings and reality. Earnings for the first quarter were originally expected to rise smartly but the closer we got to the reporting period the lower the estimates went. What hasn’t been reduced are the estimates for the rest of the year which if realized would see earnings rise over 8% over last year. That seems unrealistic given the weak sales environment. Earnings in this cycle have been the worst in the last 50 years and ultimately stock prices do follow earnings. Yes, they can diverge for a while as we’ve seen the last couple of years but measured across a full cycle. they track pretty closely.
While earnings are not directly a function of GDP growth, sales growth is obviously important to long term earnings growth. The last few years companies have been able to grow earnings much faster than sales by keeping a lid on expenses (profit margins near all time highs) and using cash to buy back stock. There would seem to be a limit to that though and at some point – I would argue fairly soon – earnings and sales growth will have to converge. That brings us back to economic growth and that is an ongoing concern. The US economy has been growing at roughly 2% for the last few years and I don’t think that is likely to change over the long term. In fact, the average real growth rate over the last 40 years is just a bit over 2% despite the wide spread belief that the potential for the US is closer to 3%.
That expectations gap I think is bound to be disappointed. As I’ve pointed out before, long term growth is a function of demographics and productivity. Unfortunately, population growth has slowed and we’re getting older while corporate investment, which determines long term productivity growth, has been falling for a long time. I would argue that stocks do not currently reflect the new normal – which is actually pretty old – of 2% growth. At some point reality will have to be priced into current stock prices.
Of course, that is in the aggregate and also only considers US growth. With nearly half of S&P 500 earnings coming from outside the US, growth in the rest of the world matters a great deal. There are better demographic and productivity trends in other countries, primarily in emerging markets. Companies that have direct exposure to those countries seem likely to do better over the long term than those that don’t. In the short term that probably isn’t true as emerging market countries’ fates are inevitably linked to China which appears to be struggling a bit at present. Indeed, IBM reported very weak earnings in emerging markets and other companies, such as Proctor and Gamble, have reduced estimates due to emerging market currency effects.
In the long run, stock prices will reflect earnings growth and I think expectations in that regard are still too high. It will be interesting to see how the rest of the earnings season develops, particularly with regard to company outlooks, and how stock prices react. Investors would be wise to mind the expectations gap.
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