What is Earnings Growth Telling Us About the Health of the U.S. Economy?

While third quarter preliminary GDP numbers look fair at best, showing growth at 2.1 percent, some key statistics show that the economy may be showing signs that are worrisome, most particularly corporate profits.  Data from Factset shows us how weak Corporate America's earnings have become in the last quarter of 2015, particularly in the energy and materials sectors.  

Here are three metrics that are showing stress:

1.) Earnings Growth: For Q4 2015, earnings are estimated to decline  at -4.3 percent.  This is much higher than the expected decline of -0.8 percent projected on June 30, 2015.  If this projection is accurate, this will be the first time that the index has seen three consecutive quarters of year-over-year declines in earnings since Q1 2009.

2.) Earnings Guidance: for Q4 2015, 83 companies have issued negative earnings per share guidance and only 26 have issued positive earnings guidance.

3.) Earnings Revisions: On September 30, 2015, the estimated earnings decline for Q4 2015 was -0.6 percent with eight sectors now showing lower earnings growth rates when compared to the September 30 date.

On a per-share basis, estimated earnings for Q4 2015 have fallen by -3.4 percent since September 30, 2015, a much larger decline than the five year trailing average of -2.7 percent.  Of the ten sectors of the economy,  five sectors are projected to report year-over-year growth in earnings with five sectors showing year-over year declines in earnings.

Here are the two biggest winning sectors on a year-over-year basis in terms of earnings:

Telecom Services - earnings growth rate of 27.3 percent

Financials - earnings growth rate of 10.4 percent

Here are the two biggest losing sectors on a year-over-year basis in terms of earnings:

Energy - earnings decline rate of 65 percent

Materials - earnings decline rate of 22.9 percent

It is important to keep in mind that most of the earnings growth in the Financial sector are due to earnings growth at Citigroup where earnings growth is projected to be $1.20 per share in Q4 2015 compared to $0.06 in Q4 2014.  Without Citi's contribution, growth in the Financial sector would only be 3.5 percent instead of 10.4 percent.  In the case of earnings declines in the Energy sector, the Oil and Gas Exploration and Production subsector is predicted to experience the largest year-over-year decline in earnings, a very substantial decline of 147 percent in Q4 2015.  In the Materials sector, the Metals and Mining subsector is predicted to experience the largest year-over-year decline in earnings with a drop of 64 percent in Q4 2015.

Here is a graphic showing earnings growth/shrinkage for all ten sectors for the fourth quarter of 2015:

Note that in eight sectors, earnings growth in Q4 is projected to be lower than the level projected on September 30, 2015 and earnings shrinkage for the five most poorly performing sectors are expected to be larger than originally anticipated.

Not only are earnings expected to drop in Q4 2015, the drop in revenues that has taken place over the past three quarters is expected to continue with a drop of 3 percent.  This is the first time that the index has seen four consecutive quarters of declines in revenue since the period between Q4 2008 and Q3 2009.  Of the ten sectors of the economy, four are expected to show declines in revenue during Q4 2015 (led by Energy and Materials) and six are expected to see revenue growth (led by Telecom Services and Health Care as you can see on this graphic:

Note that in eight of the ten sectors, revenue growth is projected to drop more in Q4 than was projected on September 30, 2015.

Let's close this posting by looking at the latest price-to-earnings data for the U.S. stock markets from Robert Shiller:

At its current level of 26.6, the price-to-earnings ratio is well above its long-term average of 16.54.  In fact, it is very close to its peak value since the beginning of the Great Recession (26.99).   If, in fact, the Factset projections about earnings in Q4 2015 are accurate, investors may find that the stock market is way, way overvalued, a situation that will put significant downward pressure on stock prices when it becomes very clear that a substantial part of Corporate America is suffering.

  

What is the CAPE Ratio Telling Us About The Stock Market?

Updated October 13, 2015

The recent correction/downturn in the stock market seems to have taken many investors, both big and small, by surprise.  If one looks at historical stock market valuations, particularly price-to-earnings data, it is quite clear that the recent volatility to the downside should have been anticipated.

Robert Shiller, famed for his housing market index, has also accumulated a very large database of monthly price-to-earnings ratios for the stock market going all the way back to January 1871.   This data set includes monthly stock prices, dividends and earnings data along with the consumer price index (CPI-U) that allows the data to be converted to real/inflation-corrected values.  Stock price data are monthly averages of closing prices.  From this data, Dr. Shiller calculates the CAPE or Cyclically Adjusted Price-Earnings ratio which is also known as the P/E 10 ratio.  The CAPE ratio is defined as the price of stocks (or the stock market as a whole) divided by the moving average of ten years of earnings adjusted for inflation.  Higher than average CAPE values suggest that there will be lower than average long-term annual returns and lower than average CAPE values suggest that there will be higher than average long-term annual returns on stocks.  If you are interested, you can find Dr. Shiller's dataset here by clicking on the U.S. Stock Markets 1871 - Present and CAPE ratio.  If you wish to see the individual CAPE value for any given stock, please click here.

Now, let's look at a graph that shows the CAPE value from 1881 to the present:

We can quite clearly see how volatile the CAPE ratio has been over the fourteen decades and can see how it peaked and and dropped prior to and during the Great Depression, during the tech sector boom and bust of the late 1990s and early 2000s and how the CAPE ratio dropped during the Great Recession.  Over the past 134 years, the CAPE ratio has averaged 16.65 and has fallen in a range of between 4.78 in December 1920 and a peak of 44.2 in December 1999.  According to Dr. Shiller's calculations, on October 2, 2015, the CAPE ratio was 24.78.  According to this website, on October 13, 2015, the CAPE ratio was 25.49.  These values tell us that the stock market is still significantly overpriced compared to the 134 year average of 16.65 and that the recent correction should have come as no surprise to investors.  In fact, at either 24.78 or 25.49, the present CAPE ratio is still in the top 10 percent of all valuations over nearly a century and a half.

Here is a graph showing what has happened to the CAPE ratio since the beginning of the Great Depression in December 2007:

Over the 93 months, the CAPE ratio has averaged 25.34 and has fallen in a range of between 13.32 in March 2009 and a peak of 26.99 in February 2015.  

I can recall during the tech sector boom that many analysts suggested that the concept of price-to-earnings was no longer applicable to stock valuations, particularly since many tech sector companies had almost no earnings and extremely high valuations.  As we learned rather painfully, this was not the case and Dr. Shiller's analysis proved to be correct in the long-run.  At this point in time, it appears that the American stock market is still significantly over-priced when one compares present earnings to share prices to the levels experienced over the past century and that we should expect further volatility to the downside in the future.

The Price-Earnings Ratio and the Overbought Stock Market

Updated February 17, 2015

The recent volatility in the stock market has come as shock to many investors, however, looking at historical data, we shouldn't really be all that surprised.

Back in 2000, Yale Professor Robert Shiller, co-creator of the widely quoted Case-Shiller U.S. Home Price Index, wrote a book called Irrational Exuberance.  In the book, he used a data set consisting of monthly stock prices, dividends and earnings to ascertain whether or not the stock market is overvalued compared to historical levels.  The data which goes back all the way to 1874  and which is available here, is used to calculate the Cyclically Adjusted Price Earnings Ratio (CAPE or PE 10 Ratio).  There are currently just over 1720 data points in the set.  Dr. Shiller uses monthly dividend and earnings data that are computed from the S&P four-quarter totals for each quarter since 1926 which are then linearly extrapolated to month figures.  Stock price data is the monthly average of closing prices.  CAPE is defined as the stock price divided by the moving average of ten years of earnings corrected for inflation using the Consumer Price Index.  Higher than average CAPE values have a tendency to mean that average long-term annual returns will be lower and lower than average CAPE values have a tendency to mean that average long-term annual returns will be lower than average.

Here is a graph showing the entirety of the dataset:

Since 1881, the CAPE ratio has averaged 16.57.  On January 13, 2015, the CAPE ratio stood at 27.60, 66.6 percent above the cyclically adjusted 133 year average.  The bump in 2000 is a result of the technology stock frenzy when traditional valuations went out the door in the "new electronic economy".  We all know how that story ended, don't we?

Let's take a closer look at the CAPE ratio in the "modern era" from 1970 to the present (and yes, I know that I'm randomly picking a year):

Over the 45 year timeframe, the average CAPE ratio was 19.48.  The current CAPE ratio of 27.60 is still 41.7 percent above the cyclically adjusted 45 year average CAPE.

A brief look at Dr. Shiller's Cyclically Adjusted Price Earnings Ratio data would certainly suggest that the September 2014 stock market was overbought when compared to historical levels.  With this in mind, the current correction should not have been a shock to investors who were piling into the stock market in a rabid search for a decent return on their savings, thanks in large part to Mr. Bernanke and Ms. Yellen and their unshakeable belief in their zero interest rate policy.