God is a Capitalist

Tuesday, March 17, 2015

Earnings stumble

Despite what mainstream finance and economics teach, the stock market is rational. Two things drive it - profits and risk tolerance, or as they say in finance, the discount rate. Both have advanced the stock market from its lows at the bottom of the latest recession to recent record highs as profit rates and risk tolerance soared so that investors have been willing to pay more for the same profits.

As of the writing of this post, the S&P 500 is down about 3% from its record set on March 2. Some of the selling could have come from profit taking or covering shorts, but much of it is due to concerns about future earnings. Last week I showed that profit rates are at record highs and reasonable investors would assume such rates are unsustainable based on the history. And that seems to be the case as Seeking Alpha's Brian Gilmartin wrote:
Looking at the first half of 2015, analysts are now projecting year-over-year declines in both earnings and revenues for both Q1 and Q2 '15, compared to expectations for earnings and revenue growth for both quarters back on December 31 '14.

Gilmartin's sources expect a 2.7%  drop in earnings for Q1 2015 compared to Q1 2014, and a 0.1% drop in Q2 before a rise of 2.2% in Q3. However, he goes on to show the impact of the drop in earnings from the oil industry, which are large, and then the earnings from the rest of the market excluding the energy sector. Obviously, earnings look much better when you exclude the losing sectors, but that type of analysis is what advisers do at market tops in order to convince people that the market will go higher. There is little reason to assume that the collapse in energy sector profits will have little impact on other sectors.

All sectors are not equally important, though. If you follow mainstream economics/finance you will fixate on profits in consumer goods industries, assuming consumer spending will force investment in other sectors. But followers of Austrian economics understand that production generates consumption. In fact, high profits in the consumer goods sectors are a harbinger that the Ricardo Effect is about to force a reversal in the economy. That's why falling profits in mining and energy are warning signs.

Computers are another part of the capital equipment sector and an early warning omen. The world’s largest chipmaker, Intel, fell 4.3 percent last week to its lowest level since October after the company announced that Q1 sales will be less than forecast, "citing lower-than-anticipated demand for corporate computers and weakening economies, particularly in Europe."

Hayek emphasized in Profits, Interest and Investment that businessmen pay little attention to interest rates, focusing instead on profits as their guide investment decisions. Profits rise to record levels when businessmen quit investing and store up cash because investments are recorded as expenses. Record profits are a sign of a weakening economy.

You can find evidence that businessmen are reducing investments in the near zero productivity growth rate recently, but more so in the volume of their own shares bought by corporations. Here is a chart from AAII that shows how much corporations have spent on stock purchases and dividends.

Dividends and stock purchases are at record levels since the recession. Just as important is the observation the author makes that corporations are terrible market timers. Like most individual investors, they buy most of their own stock the higher the market gets, making such purchases a contrary indicator.

A lot of advisers expect profits, and thus the market, to bounce back later in the year, but history tells us that when profit rates begin to fall they continue for quite a while. And falling profits destroy the optimism that fuels risk tolerance, which means the discount rates will fall along with PE ratios. 

No comments: