SERIOUS MONEY:Rally provides some cheer, but weakness outside the financial sector persists
JOHN PIERPONT Morgan, who was born on this day in 1837, when asked what he thought the stock market would do in the future, replied succinctly that “it will fluctuate”.
Investors have endured wild fluctuations in share prices over the past 18 months as volatility surged and market indices recorded their steepest decline since the 1930s. The almost relentless drop in equity values through the final quarter of 2008 and the opening months of this year has come to an end as investors have seized upon the improving rate of change apparent in recent economic data as reason for hope.
The newfound enthusiasm has seen stock prices jump more than 25 per cent from their March low and trade above their 100-day moving average for the first time since the worst of the bear market got under way last summer. The rally has been impressive, but its moment of truth is certain to come in the weeks ahead as the first-quarter earnings season puts its credentials to the test.
Corporate America’s second longest earnings expansion over the past half-century came to a halt during the third quarter of 2007 and the cumulative drop in operating earnings per share already exceeds 45 per cent, with more to come through the first three quarters of this year. More than one-third of the damage to corporate profits came during the final quarter of last year as revenues suffered a double-digit decline year on year and operating earnings dropped into negative territory for the first time since Standard Poor’s began keeping records.
The first-quarter reporting season has got off to a good start. Both Goldman Sachs and Wells Fargo have beaten analysts’ expectations. But the welcome cheer may prove short-lived as severe weakness outside the financial sector becomes apparent.
Economic data shows that industrial production dropped 14 per cent year on year in January and February, capacity utilisation declined more than 10 percentage points over the past 12 months while the inventory to sales ratio over the same period has revealed a double-digit rate of increase. The data points to declining demand and soft prices, a combination that should result in a savage decline in profits outside the financial sector.
The steepest earnings downturn in several decades follows an extraordinary profit expansion that saw return on equity and margins soar to levels that were well beyond historical experience. Operating earnings per share advanced 135 per cent – eg, an annualised rate of 17 per cent, from the trough during the final quarter of 2001 to the subsequent peak during the summer of 2007 – while nominal GDP increased by 34 per cent, an annualised rate of 5½ per cent over the same period.
The surge in corporate profits saw its absorption of GDP jump to a record high of 14½ per cent and, though the share of GDP has since fallen to 10 per cent, it is still three percentage points above the absorption rate apparent at previous troughs.
This suggests that operating earnings could easily drop a further 30 per cent from current levels for a trough in profits per share of just $35.
It is important to note that these are operating numbers or earnings before exceptional and extraordinary items. The figures, including write-offs, have dropped by more than 80 per cent from their cycle peak, a decline of greater magnitude than the downturn in earnings from 1929 to 1932, but in line with the collapse in profits from 1916 to 1921. The evaporation of reported earnings has emerged as write-offs have surged from 7 per cent of operating profits in the summer of 2006 to almost 70 per cent during the final three months of last year.
Careful analysis suggests that the four-quarter reported number could well be in negative territory during the second and third quarters of this year.
Investors should be aware that, although the current earnings downturn is nothing short of savage, depressed earnings numbers should never be used to value the market.
A properly constructed valuation analysis should be based on the stock market’s long-term earnings power. A relatively simple model using real profits as opposed to the employment of nominal figures reveals that current earnings power is $60 per share. The analysis includes supposedly once-off charges that have averaged more than 15 per cent of operating earnings over the past 20 years, which clearly demonstrates that what is extraordinary for one company is not so for the market in aggregate.
The use of profit numbers that reflect long-term earnings power indicates that the market is currently trading on a multiple of 14, which is below average though not particularly cheap. Investors must also consider whether the collapse in corporate profitability has caused a permanent reduction in trend earnings from the current estimate of $60 per share. This phenomenon happened before when earnings peaked in 1916 at similarly elevated levels relative to trend only to register a record-breaking undershoot at the trough five years later. The original trend was never restored and the long-term growth rate in real earnings of 2 per cent per annum resumed from a lower level.
Stock prices have registered a meaningful advance from bear market lows, but waning trading volume is cause for concern and a disappointing earnings season could easily precipitate a setback.
Market indices may well have bottomed, but too many structural questions remain unresolved for investors to even consider chasing prices higher.
The current advance is at best the beginning of a cyclical bull market against the background of a continuing secular bear and at worst a sucker’s rally. Investors would be well-advised to be patient for now.
charliefell@sequoia.ie
