| The Trouble with Earnings |
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| Written by Matt Blackman | |
| Saturday, 08 March 2008 | |
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The Trouble with EarningsBy Matt Blackman On Monday, the new richest man in the world, Warren Buffett, added his voice to the economic debate saying that the U.S. is essential in a recession even if it has yet to formally meet the technical definition of one. “I would say, by any commonsense definition, we are in recession,” he opined on CNBC. His comments coincided with the release of Berkshire Hathaway’s annual letter to shareholders along with the company’s 2007 financial report in which he admitted that the insurance industry will see lower underwriting profit margins in 2008. His is one of the more credible and most listened-to voices to date lending support to the contention that a recession is in our future and it goes against such heavyweights as George W. Bush and Ben Bernanke who still would have us believe that we will avoid one.
Figure 1 – An updated weekly chart showing the price/earnings ratio of the VectorVest Composite Index, a composite of more than 8300 stocks trading on US exchanges. It is a much broader and more accurate look at overall corporate health compared to the Dow Jones Industrial Average of 30 companies or even the S&P500 Index of large cap companies. As we see, the PEs first peaked in March 2000 at 32 as both the S&P500 and Nasdaq Composite Indexes peaked. But as we see, after falling briefly, PEs began to rise again in early 2001 ultimately peaking at 61 in May 2003. Chart by VectorVest.com They are not alone. As stock prices have continued to get beaten up, the majority of fundamental analysts and economists have been doing their level best to convince us that there are more bargains and the time to buy has never been better. It all began as the sub-prime problems began to break more than a year ago when we were told that the problem “was contained.” But while the credit situation continued to deteriorate pulling the U.S. economy down with it, the analysts have repeated their steadfast mantra that valuations remain attractive and buying opportunities abound. As proof they point to an attractive price-to-earnings ratio for the S&P500 at around 18. And until lately, analysts never tired of telling us that (with the possible exception of financials) earnings have remained strong. So are concerns for a market meltdown and recession overblown and do these stock bulls have a point? Are we simply going through a necessary correction and is it a good time to go shopping for bargains?
Figure 2 – Chart showing historic annual changes in earnings per share for the S&P500 showing the approximate earnings cycle, the last decline in 2001 of 50% followed by another drop in 2007 and current forecast for a 2008 earnings decline. Chart CrestmontResearch.com A little history In the five years between 2002 and 2006, earnings increased a double-digit growth rates which according to Crestmont Research’s Ed Easterling represents the average earning (Earning per Share) growth cycle. Over the last six decades, Easterling has observed that earnings typically grow for three to five years, decline for a year or two before resuming a new growth cycle. The takeaway is that buying in the fifth year of an earnings cycle when earnings growth has begun to decline and the economy was slowing would have generated negative returns over the ensuing few years. Given that the data clearly indicate that we are in such a period now, why are so many financial industry pundits still preaching buy, buy, buy?
Figure 3 – The EPS cycle is easier to see in this chart of the three-year moving average of earnings showing the latest decline below the long-term average annual growth rate of 6.6% in 2007. Chart CrestmontResearch.com Earnings – Present and Future Our research tells us that stock price is the best leading market indicator. The problem in volatile times like we are currently experiencing is that we only know when we were getting a long-term buy signal in retrospect. At present, stock prices have been falling so it’s not a good time to buy if price is your guide. But could this just be a temporary correction and still represent a good buying opportunity? Earnings growth is another good indicator of corporate health – investors buy stocks when they believe corporate earnings will improve. Earnings may be declining now but if forecasted earnings are improving, it may signal a bottom in the very near future. According to Easterling, S&P500 2007 earnings per share as of December 31, 2007 were estimated at $76.56 for a PE ratio of around 18. This compared to a final 2006 EPS of $81.51 so earnings estimates were clearly on the slide. By January 23rd, the 2007 estimate was cut to $74.15 and by February 13th it had dropped to $71.20. What about earnings forecasts for 2008? In December 31st they were $83.98, and dropped to $83.70 by January 23rd and to $71.20 by February 23rd. This represented a forward S&P500 PE of 20. More importantly as earnings forecasts have fallen, the forward PEs have risen.
Figure 4 – Quarterly earnings reports for the more than 4000 companies as tracked by the Wall Street Journal. As of the week of February 29, Q4-2007 and with about 1000 companies still to report, earnings had fallen 54% from the same quarter in 2006. This compared to -37% the week before and -21% for Q3-07 and increase of 13% in Q2. A warning about PEs Does a PE of 20 represent a sell signal? Looking at the bigger picture, do PEs provide us with any guidance on whether it’s a good time to buy? Common wisdom suggests that it’s good to buy when the ratio is low and bad to buy when it is high. To answer that question, let’s go back and look at Figure 1 which shows the PE for 8300 companies trading on US exchanges. Granted that peaks in PE followed by a breakdown would have been a good time to sell up to March 2000 but like the breakdown in price, such signals were only clear in retrospect. Each subsequent peak in PEs was higher than the last which meant that if you sold when PEs hit their prior peak, you would have been out too early. But look what happened after March 2000. PEs fell hitting a bottom of 21 in late March 2001. Would that been a good time to buy? For the short-term trader maybe but after a brief rally, prices fell significantly to September 2001 rallied again before falling again to put in a lower low in mid-October 2002. The PE at the time was 32 – certainly by historic standards not a time to buy. But as it turns out (again in retrospect), it would have been the best time to buy. Then as stocks began to put in a series of higher lows and higher highs indicative of an uptrend, PEs began to rise. Why? Investors began anticipating that earnings would begin to improve before it happened. The result was rising prices and falling earnings which pushed PEs significantly higher. Two months after the March 2003 bottom was put in, the PE moved above an unprecedented 60 which for the PE follower would have indicated a strong sell signal. However, that would have been a big mistake as the four-year rally was just getting underway and earnings were beginning to bounce back with a vengeance. Cleary, PE ratios provide a cloudy picture at best. At worst they provide selling signals at the worst possible time. Earnings trend So is earnings growth the metric to watch?
Figure 5 – Weekly chart of the VectorVest Composite of 8300 stocks together with earnings growth (GRT). In March 2000, earnings were growing. They hit a bottom then rebounded in February 2002. Both would have been a bad time to buy. Chart by VectorVest.com Take a look at earnings growth in Figure 5. At the March 2000 peak one to three year historic and forecasted earnings growth in percent per year (GRT in red) was rising and those who used it as an excuse to buy were in for a shock. GRT continued to rise for another month before leveling and didn’t begin to drop until October 2000. GRT again began to rise in February 2002 but that would have been a decidedly bad time to buy stocks. It took stocks another year to put in the final bottom and begin a bona fide recovery. Lately while GRT has dropped slightly, the drop came well after stocks began so provided little if any advance warning of stock weakness. In other words, no conclusive signals here. Timing Takeaway In our extensive research on indicators to help us get in the market at the best times and out to avoid the meltdowns, we have come to the conclusion that fundamentals while useful in long-term trends, provide poor signals at key turning points. But let’s not throw the baby out with the bathwater. A number of factors taken together to build a composite picture provide a clearer view. As Ed Easterling and the folks at Crestmont Research have shown, there are clear, definable earnings cycles that rule the markets and while using them for advance signals to get in or out may be a challenge at best, ignoring the overall earnings environment can be a painful portfolio experience. Picking a bottom is virtually impossible for most and if lucky a trader may accomplish this goal once or at best twice in his or her professional life. But this talent involves a lot of luck. It is safe to conclude that we are now entering the earnings winter and the chances that stocks will continue to fall are far greater than that of a miraculous turnaround. At times like these it is essential that investors keep their powder dry. Trying to find a bear during hibernation season wastes valuable time, energy and ammunition that are best saved for spring when warmer weather makes the animals more active again when they will provide better and far more plentiful targets. ----------------------------------------------------------------------------------------------------------------------------------------- If you find this newsletter insightful, please feel free to forward this newsletter and share it with a friend (or simply have them opt-in free from our home page http://www.tradesystemguru.com to be added). DisclaimerTradeSystemGuru.com obtains information from sources deemed to be reliable; |
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