Sunday, 16 November 2008

Imminent Earnings Meltdown

I've been closely following US corporate earnings for a better part of a year now, and for good reason. More than a year ago I argued that analysts are perennial optimists and are unable to anticipate changes in the earnings cycle and thus when a change occurs they have to play catch up.

more than a year later and they are still playing catch up. Just 4 months ago, analysts expected 3Q08 S&P500 operating earnings to show a double digit increase. As of last week, 91% of S&P500 companies have reported earnings and have registered a decline of -21.6%.

Notice in the graph above how sharply earnings expectations declined as the reporting season got underway. That trend is now playing out in the graph of 4Q08 expectatons below.

Earlier in the year when 4Q08 earnings expectations were expected to rise in excess of 70% I said that was ridiculous and they would end up being slashed. As of last week those expectations are a more realistic 26%. However that is still way too high.

A couple of months ago I would have said a 10 - 15% increase in 4Q08 earnings would have been possible given that earnings dived off a cliff in 4Q07, thus making the current quarter's comparisons much easier. However, now I believe 4Q08 earnings will be much worse.

As seen above 4Q07 represents the trough in earnings for the current cycle. However, in light of the tsunami of downgrades for 4Q08 in the last couple of weeks, I am confident that the $15.22 of earnings in 4Q07 will be breached to the downside in 4Q08. In fact 3Q08 may even come close when you consider that more than $2.30 was lopped off 3Q08 operating earnings just in the latest week.

Why will 4Q08 be so bad? Take a look at the chart below from What this shows is the ratio of earnings upgrades to earnings downgrades for S&P500 FY08 earnings. A number greater than 1 means more upgrades than downgrades whilst a revisions ratio of less than 1 means more downgrades than upgrades.

As you can see, the revisions ratio for the S&P500 is currently at 0.33, which means for every upgrade there are 3 downgrades for FY08 earnings. Healthcare is the only sector with more upgrades than downgrades. In the consumer discretionary sector, there are 6 times the number of downgrades as upgrades. This, in my opinion, will result in 4Q08 earnings falling below $15.Why the sudden huge increase in earnings downgrades? Until recently, most of the earnings destruction was in the finacial sector, however that has now spread across the entire economy.

So what you say, the stockmarket has already discounted a horrible fourth quarter and is looking ahead to 2009. If you go back to the chart showing actual and forecast S&P500 earnings, you can see the nice linear path that analysts have mapped out for future earnings to return to record highs by 4Q09. Mark my words, there is no way in hell US corporate earnings will be reaching record highs by the end of next year, that is fantasyland stuff. But don't take my word for it, take a look at the revisions chart for FY09 below.

The revisions ratio for FY09 is currently at 0.13 which means that there are a staggering 8 downgrades for every upgrade to FY09 earnings. Even the healthcare sector has more downgrades than upgrades.

As shown below, FY09 earnings forecasts have started to fall precipitously in the last few months. Currently FY09 S&P500 operating earnings are forecast at $91.85. That is way too high, my best guess at the moment would be somewhere in the vicinity of $60.

Slap a 12 multiple on S&P500 earnings of $60 and you get an S&P level of 720. Thus it is easy to see how the S&P500 can go substantially lower from current levels. This is not a forecast but just an indication that the stockmarket can go signifcantly lower and still not be ridiculously cheap.


Anonymous said...

Most interesting analysis.Similar optimism in OZ re Bank SPs.NAB etc bargin as Div. is 14%(after franking).Don't think so as a dead set be lowered--not immediately of course!
On another tack,Gold was up on Friday as was the Dollar Index--unusual combination.
Keep up the good work!

The Fundamental Analyst said...

Yes, Aussie bank yields look quite attractive if you think they can live up to those dividend forecasts. I think recent market action suggests that those forecasts will not be met.