The Earnings Recession Continues

With over 83% of the S&P 500 having reported earnings for fourth quarter 2015, it is clear that the bullish reversal to 2014 earnings levels has failed.   This post explores the earnings picture that continues to disappoint and some of the valuation issues that have developed. 

• S&P 500 earnings are important fundamental support for the US equity markets; both operating earnings and as reported earnings peaked in third quarter 2014 ($29.60 and $27.47 per share respectively).    The S&P 500 closed at 1972 at the end of 3Q14, with PE ratios of 17.2x and 18.6x operating and reported earnings, respectively.
• Standard and Poors has long forecast that fourth quarter 2015 would mark the reversal of this trend, forecasting a big gain in operating earnings to the $29-30/share range; if this forecast was achieved, it would represent an 18% quarter-over-quarter gain and a return to the old highs.
• At the headline level, all seemed on track as an above average 68.7% of the S&P 500 beat earnings estimates; even the Energy sector showed a 69.5% beat rate, third best after IT and Materials.
• As we have seen so many times over the past few years, even with high beat rates, with 83.8% of the S&P 500 reporting, operating earnings forecasts have dropped precipitously to just $26.19/share and $22.74/share for operating and reported earning;  in just six weeks, the forecasts have dropped an incredible -9.7% as actual earnings were reported.
• At the beginning of 2015, it was thought that full year earnings would reach a record $131/share, a respectable 16% gain from 2014.   Instead, earnings will likely be just $103.50/share, or over -8% lower year-over-year.    We have not seen a year-over-year drop in earnings since 2008.
• Despite the recent modest correction in equities, the S&P 500 is now trading at 18.5x trailing 12-month operating earnings and 21.1x reported earnings.
• At the index level, PEG ratios (PE ratio compared to projected annual growth in earnings) continue to climb, reaching a robust 1.9x, 2x, and 2.2x for large cap, mid cap, and small cap stocks, respectively.
• At the sector level, the rotation into defensive stocks have skyrocketed their PEG ratios.   Utilities PEG ratios have reached the 3.1x range, Telecom the 2.7x range, and Staples in the 2.6x range.
• It is pretty incredible what has happened to certain stocks in these defensive sectors (all statistics sourced from Morningstar) as money flows have rotated into them.   Utilities like Southern (SO) and Dominion Resources (D) are trading at 22-23x PE ratios and have declining earnings over the past three years.   Even after getting crushed Walmart (WMT) is still trading at a PE ratio of 13.7x, a rich 9.7 times its 1.4% average annual net income growth.   Pepsi (PEP) is trading at a PE ratio of 27.1x with -4.1% average net income growth over the past 3 years.    McDonalds (MCD) and General Mills (GIS) have similar statistics with 24-25x PE ratios and contracting net income.   The kingpin of this list of richly valued defensive stocks is Kellogg (K), trading with a PE of 74.6x with -10% average net income growth over the past three years.
• In 4Q03 S&P 500 operating earnings finally regained their approximate level before we entered the 2000-02 recession.   Over the next four years of the expansion, the S&P 500 had an average operating PE ratio of 16.88x.   Midway in the expansion at the end of 3Q06, the S&P 500 had an operating PE ratio of 15.5x, the low for the series.   These PE ratios were experienced when earnings were generally trending higher, not falling.
• Based on 2015 operating earnings, a PE ratio of 16.88 would imply an S&P 500 level of 1748; at 15.5, the S&P 500 would be in the 1605 range.
• The S&P 500 is now trading at about -10% below its all time highs, and the stress level for investors is quite high.   It will be higher, when the implications of the on-going earnings recession are fully understood.