The Dark Side of Earnings

Over time, it is corporate earnings that drive stock valuations. On any particular day, stock prices may be up or down for a wide variety of reasons. But in the long run, if earnings are rising, stock prices will be, too.

This should be comforting, as it gives you a metric by which you can gauge sell-offs. In other words, if the market is weak, you can ask, “How does this affect earnings?” If there’s no compelling answer, then you probably have a dip that can be bought. 

From that perspective, it’s easy to see why the market sold off on Chinese economic news in August and September. China’s economy is slowing as the government attempts to hasten the transition from an export-driven economy to one that can be sustained by consumer spending.

As you know, the pace of Chinese industrialization has been incredible. In four years (2010 to 2013), China poured more concrete than the U.S. did in the entire 20th century. It’s no big surprise that countries and companies that produce commodities raised their production as fast as they could.

So it should also be no surprise that as China’s economy slows, it isn’t using as much concrete, iron ore, steel, and copper as it did just a couple years ago. And so commodity-dependent economies, like Brazil, Australia, Indonesia, etc., are struggling.

All of this definitely has the potential to drag U.S. corporate earnings lower.

“The industrial environment’s in a recession. I don’t care what anybody says,” — Daniel Florness, CFO Fastenal

So now that we’re about a quarter of the way through third-quarter earnings, we can start to look at how companies are doing.

105 members of the S&P 500 have reported. Zacks says earnings are up 0.4% over last year and revenues are down 1.7%. Surprisingly, that’s better than what analysts were expecting. Right now, analysts still expect earnings to be down 2.8% for the third quarter.

But it’s still not good, especially the revenue numbers. Just 45% of companies are beating on revenue. And when it’s all said and done, analysts say that revenue will be down 4%. The last time revenue and profits fell in the same quarter was 2009.

Now, the fact that revenue is falling faster than earnings is noteworthy. On the one hand, the earnings numbers suggest that companies are still able to raise productivity, basically doing more with less. But there’s another side to the earnings/revenue mix.

The Dark Side of Earnings

Part of the reason companies can beat on earnings but miss on revenue is because of share buybacks. Companies have been spending around $1 trillion a year buying back their own stock. And while that makes earnings per share better, it can’t hide their revenue weakness, as we’ve discussed before.

Not only that, but companies have used low interest rates to borrow against their cash to buy back stock, so the balance sheets look good until you get to debt levels and interest expense. Annual interest expense is now higher than it was in 2006. And this will become a drag on earnings, too — especially when the pace of buybacks slows and interest rates rise.

The musical chairs metaphor is certainly appropriate here. Valuations look decent while the buyback music is playing. But if there’s no real growth when the music stops, it will be a problem.

Of course, analysts are looking for real growth in 2016. But analysts are pretty much always optimistic about the future. And they are almost always overly optimistic and have to revise lower. So while we may not need to be outright pessimistic about future earnings, we must acknowledge that plenty of threats remain.

In a nutshell, that’s why prices have been so volatile and why they will likely remain volatile for the foreseeable future.

Back to the Future

We’ve seen it twice now. The first was in May of 2013, and the second was August 2015. Both of these dates are times when the Fed had indicated that changes to monetary policy were coming.

May of 2013 was the Taper Tantrum, when stocks sold off after former Fed chief Ben Bernanke announced that the Fed would be winding down QE3.

And this past August, investors were convinced that current Fed chief Janet Yellen was going to hike interest rates.

In both cases, stocks sold off because of the Fed. And what’s more, the incredible rally we’ve just seen occurred simply because of a change in expectations about monetary policy: Yellen didn’t hike U.S. interest rates, China lowered its interest rates, and European Central Bank chief Mario Draghi said he was considering more stimulus for the EU economy.

That’s all it took to send the S&P up 8% in a few weeks.

The stock market is telling us a few things: 1) the global economy is weak; 2) investors do not care about economic growth so long as monetary policy is easy; 3) when monetary policy changes, stocks will sell off more than 10%.

I still say that investors and the stock market need to be weaned off of the Fed’s easy money. I also understand that the Fed does not care what I think. But at least we know what to look for in the months ahead.

Until next time,

Until next time,

Briton Ryle

@BritonRyle on Twitter

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A 21-year veteran of the newsletter business, Briton Ryle is the editor of The Wealth Advisory income stock newsletter, with a focus on top-quality dividend growth stocks and REITs. Briton also manages the Real Income Trader advisory service, where his readers take regular cash payouts using a low-risk covered call option strategy. He is also the managing editor of the Wealth Daily e-letter. To learn more about Briton, click here.