Falling Earnings Forecasts Belie New Highs in Stocks
New York (Feb 26) Wall Street rallied to records Tuesday after Federal Reserve Chair Janet Yellen's Congressional testimony indicated interest rate hikes weren't in the offing anytime soon while the economy continues to chug along. And so stocks and bonds gained in tandem in this best of all possible worlds of easy money, subdued inflation and moderate growth.
But what if the real risk to financial markets isn't rising interest rates, as the consensus assumes, but renewed recession? To most investors, that would seem to be about as likely as getting heatstroke in the deep freeze that has engulfed much of the U.S.
But, according to Societe Generale strategist Andrew Lapthorne, the steep decline in U.S. corporate earnings forecasts in the past month has been the worst since the financial crisis. To dismiss this as simply the product of falling energy prices and the rising dollar may be misguided, he writes in a research note.
To be sure, that runs totally counter to the consensus opinion, which sees growth in U.S. gross domestic product perhaps slowing from the 3.75% annual growth pace in the second half of 2014, but still powering ahead in the 2%-3% range. And, according to conventional wisdom, as GDP goes, profits are destined to follow.
But, as he and his SocGen colleague Albert Edwards have argued, profits are not the residual aftereffect of growth but the driver of key economic decisions whether to invest or to hire. If so, "then the recent slump in consensus expectations will be of particular concern," he writes. "Those positioned for an economic acceleration may be getting increasingly nervous."
Lapthorne's tally of global earnings forecasts shows a 4.8% being cut from the coming year and 6.6% from the following year in the past three months. In just the past month, 3.3% was sliced from the coming year's forecast and 2.9% from the subsequent year. As noted, the energy sector and the effect of the greenback have been key sources of the downgrades.
"The downgrade in US forecasts last month was the worst since the 2009 financial crisis and the ratio of upgrades to total estimate changes has fallen to a lowly 35%, the worst regional result and a level typically associated with period of falling profit growth. Indeed, the six-month decline in 12-month forward U.S. [earnings per share] estimates is normally associated with a recession," he writes.
To be sure, the effects of cheaper energy and a stronger dollar are expected to lead to lower prices in the U.S. and higher disposable income for consumers worldwide.
"That may indeed be the case, but the counterevidence is certainly mounting up," Lapthorne observes.
On that score, David P. Goldman, head of the Americas for Reorient Group in Hong Kong, points out that nominal retail sales have fallen for two straight months and were down sharply in real terms in January.
Investment, he continues, "is exceptionally weak," with durable goods orders down 1% from a year ago. And that's before the announced cutbacks in the energy sector. "For the time being, the U.S. economy has the worst of both worlds: the oil price drop has crushed capex but doesn't seem to have helped the consumer."
In any case, if the global economy were picking up speed, SocGen's Lapthorne wonders, "why have 20 central banks cut interest rates already in 2015?" Economic surprises have been on the downside while most countries -- except Singapore, Ireland and Japan -- are seeing major earnings forecasts cuts even though they should benefit from the stronger dollar.
Notwithstanding the popular stock indices hitting new highs, he thinks the message from both the global equity and government bond markets are "that investors are positioning themselves for a an economic slowdown."
"For example, the relative and strong outperformance of higher-quality stocks within the equity market has been highly positively correlated with the equally strong performance of sovereign bonds, both of which have rallied on the back of weakening earnings momentum. To simply disregard this economically consistent message as being simply a function of low oil prices, low inflation and central bank actions may be misguided to say the least," Lapthorne concludes.
By maintaining their key interest rates at their crisis levels near zero -- or even lowering them into unprecedented negative territory -- the world's central bankers implicitly agree the risks are tilted to the downside. How then to reconcile that with major stock-market indexes hitting new highs?
It would appear equity valuations are being rerated against the backdrop of record-low bond yields. Rising stock prices while earnings projections are declining necessarily equate to higher price-earnings multiples.
Higher P/Es plus falling earnings would seem a dangerous equation for stocks. And a disquieting notion that is dismissed readily in rising markets -- and at tops.