If you believe, as my pal Larry Kudlow does, that profits are the mother’s milk of stock returns, then you should be concerned with the following analysis:
Corporate profit growth is decelerating — and at significantly quickening pace.
So, too, are earnings expectations for the coming year. As noted earlier this week, the S&P500 double digit year over year profit streak has ended.
The big question then, is, what might this mean for equities? In the Sunday NYT, Paul Lim looks at what this might mean:
"After increasing at a double-digit rate for several years, earnings for companies in the S.& P. 500-stock index are expected to grow by only 3.3 percent in the first quarter of 2007, according to Thomson Financial. This represents a huge drop in expectations, as Wall Street analysts at the start of this year were expecting a first-quarter growth rate of 8.7 percent.
The second quarter doesn’t look much stronger: analysts are predicting profit growth of just 3.5 percent.
And after soaring 16 percent last year, corporate earnings for the full year are expected to increase by only 6.3 percent. “Analysts have pretty much cut their forecasts in half for the year,” says Jack A. Ablin, chief investment officer at Harris Private Bank in Chicago."
Historically, earnings growth runs about 7% — roughly the combination of inflation and GDP.
Mean reversion, however, does not simply return a measure to its historical average. Rather, it oscillates above and below. While 6.3% is a respectable number for earnings growth, it is important to note that the profit growth is a cyclical phenomena, swinging wildly above (+28% a few years ago) and wildly below (minus 25% a few years before that).
The S&P’s Sam Stovall looked at prior eras of earnings growth deceleration from 1966 to 2000. The Times notes that "in 4 of the last 10 such periods, the S.& P. 500 lost value. But this means that in a majority of cases, stock prices still managed to climb in the face of slowing profits. In fact, the average gain for the S.& P. 500 during these slowing periods was a respectable 7 percent."
That 34 year period niucely encompasses two major secular periods — a major Bear market (1966-82) and a major Bull market (1982-2000). I would be quite curious to see how the breakdowns of positive and negative returns relative to earnings growth correlated to these different periods. (We are presently in a secular Bear market, running from 2000- 20??).
As the article further notes, its "not just the rate of earnings growth, but also
the underlying trends." We would much rather buy low earnings growth — but when its on the upswing — versus medium earnings growth on the downswing.
Back to the NYT:
"Periods when the earnings growth is high but falling tend to be challenging for the market, [Tim Hayes, chief investment strategist at Ned Davis Research] said. It’s during these periods, he said, that “the market begins to question the sustainability of earnings growth.” And “the market becomes vulnerable to disappointments,” he added.
Despite the swoon in stock prices in late February, the markets haven’t come close to pricing in the coming earnings slowdown, in the view of Richard Bernstein, chief investment strategist at Merrill Lynch.
“What’s happening now is an odd situation where earnings growth looks like it’s slowing, but people are hesitant to make that bet because every time they’ve made that bet in the recent past, earnings have surprised to the upside,” Mr. Bernstein said.
For the last 15 of the last 16 quarters, analysts’ estimates for earnings growth have turned out to be too pessimistic. And Mr. Thompson added that analysts have recently underestimated actual earnings by around 3 percent.
“It’s now almost become a Pavlovian response,” Mr. Bernstein said, where investors immediately bet on better-than-expected earnings once analysts post their forecasts."
Since we mentioned the recency effect yesterday, consider this: in terms of profit growth, both the most recnet data point AND the overall trend are pointing in the same direction: downwards.
Graphic courtesy of NYT
Graphic courtesy of NYT
A Caution Signal on Profits. A Red Light for Stocks?
PAUL J. LIM
NYTimes, April 8, 2007
Stax 50th Anniversary Celebration: Last year, Concord Music purchased Fantasy Records, and as a bonus, they landed the "bulging Stax
For those of you not fans of 1960s/70s Soul music, Stax was one of the richest sources of R&B, Soul and Blues. They were home to such artists as Otis Redding, Isaac Hayes, William Bell, and Booker T.
For some reason, they were overshadowed somewhat by Gordy Berry and Motown. This double CD features 50 hit singles from Stax (and Stax-Atlantic) from the labels’ 1960s and ’70s heyday, and attempts to make up some of that ground.
The WSJ had a glowing review of the set:
"Stax, the music label responsible for superior soul,
R&B and an occasional slice of the blues in the ’60s and early
’70s, is observing its 1957 founding in everything but name by
releasing "Stax 50th Anniversary Celebration," featuring 50 of the best
tracks from its vaults. It could have released twice as many, or more,
without a dip in quality. In fact, it did release twice as many in 2000
under the title "Stax Story" and almost 2½ times as many in 1991 in the
superb boxed set "The Complete Stax-Volt Singles 1959-1968." Two
subsequent collections from the archives of Stax and its Volt
subsidiary raised the number of tracks issued in the past 15 years to
652, more than 13 times what’s in the 50th anniversary box.
A joy from the first cut to the last, "Stax 50th
Anniversary Celebration" is a reminder of the glory days of R&B,
when singer, song and band came together with fervor to spark body and
soul. The music all but sweats with the musicians’ passion: There are
no drum machines and no vocal bent to pitch by software. The punchy
horns are real brass and reeds, not lines played on synthesizers. Now
and then, a musician flubs a note or misses a cue, but an absolute
reliance on musicians’ creativity can deliver brilliant pop music
that’s timeless. Especially if the vocalists are the likes of Eddie
Floyd, Otis Redding, Sam & Dave and the Staple Singers."
The Journal eds were kind enough to move the full article over to the free site for the linkfest, so you guys get an early viewing pre-weekend.
click for CNET media player
Several videos are after the jump:
Golden Oldies: Stax Releases A 50th-Anniversary Boxed Set
WSJ, April 4, 2007; Page D9