SERIOUS MONEY:Despite the recent rise in shares, expectations are far too optimistic
THE CARTOON characters Wile E Coyote and the Road Runner made their first appearance in Fast and Furry-ousduring the autumn of 1949.
The characters were created a year earlier by animation director Chuck Jones for Warner Brothers. Jones based the coyote on Mark Twain’s semi-autobiographical Roughing It, in which the 19th-century author describes the coyote as “a living, breathing allegory of want – he is always hungry”.
Equity investors were certainly starved of performance and left wanting during the summer of 1949, as the great secular bear market that began 20 years earlier came to an end. Their patience was to be rewarded as stocks delivered real returns of almost 18 per cent per annum over the subsequent decade.
Turn the clock forward to today and the rebound in the major stock market averages from their March low has been both fast and furious; the almost 70 per cent advance in prices has been the most rapid since the autumn of 1932.
The current rally has been explosive, much like the devices from the fictitious Acme Corporation, and has seen the multiple on trailing 12-month earnings almost double to 30 times, as investors began to anticipate an earnings recovery.
It is not unusual for multiples to expand off a major market low as investors typically anticipate a turnaround in the corporate sector’s fortunes with a two-quarter lead, but the current lofty multiple is without historical parallel. Corporate America simply must deliver or else gravity will pull stock prices back and investors will land with a nasty bump.
The current earnings contraction has been particularly brutal, which is hardly surprising given the severity of the economic downturn. Nominal GDP dropped in 2009 for the first time since 1949 and at the fastest rate since 1938.
The outright contraction in economic activity in nominal terms placed severe downward pressure, not only on the bottom line but also on top-line revenues, which registered four consecutive double-digit percentage declines year on year from the fourth quarter of 2008 to the third quarter of last year. Early indications for last year’s final quarter suggest that revenues have stabilised, although growth remains elusive.
Meanwhile, trailing 12-month earnings on an operating basis – eg, before the supposedly once-off bad stuff – peaked more than a year earlier at roughly $92 a share during the summer of 2007 and troughed at less than $40 a share last autumn.
The cumulative decline of almost 60 per cent ranks among the worst earnings contractions of the past century and is surpassed only by the savage drops in corporate profitability that accompanied the first World War and the Great Depression.
The freefall in profits during the current episode would have compared less favourably with these previous episodes but for the aggressive cost containment efforts by the non-financial corporate sector, which allowed margins to bottom almost two percentage points above the previous trough registered in the fourth quarter of 2001.
The current cheery consensus on Wall Street calls for a healthy increase in revenues and earnings during 2010, even though nominal growth is likely to be nothing more than pedestrian at roughly 5 per cent year on year. Revenues are forecast to increase by 8-9 per cent over the year. Earnings, driven by operating leverage, are expected to jump by more than 35 per cent to $77 a share.
Current expectations seem optimistic, given that the median increase in earnings during the first full year following an economic downturn has been a relatively modest double-digit gain of 11 per cent over the past half-century; the largest increase over the same period was less than 25 per cent.
It is beyond dispute that the corporate sector’s fortunes are inextricably linked to the economic cycle. Indeed, a simple linear regression confirms that the year-on-year percentage change in quarterly GDP, measured in nominal terms, explains almost 80 per cent of the variation in quarterly sales year on year.
Consensus Wall Street expectations look for an 8 to 9 per cent increase in revenues during the current year, which is consistent with nominal economic growth of 6 per cent.
However, consensus economist numbers call for little more than a 3 per cent advance in real GDP in 2010 and no single forecast looks for anything close to the almost 3 per cent inflation rate that would be required to produce the nominal growth consistent with current profit expectations.
It is clear, therefore, that the top-line could fall short of current expectations by a few percentage points.
The corporate sector’s pricing power is absent and likely to continue so, given the double-digit unemployment rate and close to record low levels of capacity utilisation.
Aggressive cost cuts have already taken place as businesses reacted quickly to weak demand and adjusted their operations accordingly.
The cost containment has surprised in its magnitude, but the restructuring process of itself is a normal response to an economic downturn.
Companies typically seek to maintain their margins through expense control and are initially reluctant to reduce prices as surplus capacity builds. However, further expense reduction often becomes infeasible without negatively affecting the underlying operations and businesses inevitably resort to price discounting to stimulate demand and utilise spare capacity.
Thus, company selling prices react to excess capacity with a lag and remain under pressure during the early stages of an economic expansion. Investors often overlook this fact and, consequently, it is likely that current margin expectations are too high.
Stock prices have exploded to the upside in recent months and are discounting a record- breaking surge in corporate earnings during the current year.
Careful analysis suggests that current expectations are far too optimistic and both revenues and margins are likely to disappoint. Positions in defensive stocks are recommended as gravity awaits the Wile E Coyote investors.
charliefell@sequoia.ie
