Momentum to stall as profits talked down

"You just haven't earned it yet, baby, You must suffer and die for a longer time." - The Smiths, 1986

Earnings season is upon us. And possibly we will see the US slip into an earnings recession. As US companies come clean about the first quarter of this year, much is at stake.

Earnings forecasts for 2015 have taken a stunning dive so far this year. According to FactSet, forecast earnings for the S&P 500 in the first quarter have fallen 8.2 per cent since January 1, a dive that would normally only happen in a severe economic downturn. If profit estimates from groups such as Thomson Reuters and S&P Capital IQ are correct, then the US will suffer year-on-year falls in earnings for both the first two quarters of this year. That is an "earnings recession".

Stripping out the effects of tax and cheap debt, to look at just operating profits, Ned Davis Research shows that profits fell sharply in the fourth quarter of last year, and are due to fall for the first two quarters of this year, marking the biggest and most prolonged decline since the worst of the Great Recession in 2009.

There are many reasons to be cynical about earnings season. US quarterly reporting tilts investors and management towards unhealthy short-termism. Companies talk down expectations, to get a bump in their share price when they clear the low hurdle they set themselves.

As the latest prediction for the S&P is that first-quarter earnings will reduce by about 3 per cent year on year, this is reason to suspect that the profits "recession" could turn out to be a duller flat outcome.

However, the reasons for the sudden writedown give cause for genuine concern. Two major macro shifts in the past 12 months make earnings harder to predict and, for companies, easier to obfuscate. They also naturally stoke volatility.

First, the collapse in the oil price in 2014 muddied the waters. This has an immediate, negative impact on companies that sell oil, and a slower positive impact on companies that benefit from cheaper oil.

Second, there is the strengthening of the dollar against all other currencies, most notably the euro. That makes the foreign earnings of US companies look weaker in dollars, while improving the US earnings of foreign multinationals.

A third factor, the slowdown in Europe, followed by signs of green shoots in its economy, adds another optical distortion. In Europe, expectations are now heading for the sky, with profit growth of 13.5 per cent forecast for this year compared to last, according to S&P Capital IQ.

But much of this has to do with mathematics. Earnings for 2014, still dribbling out from European companies, look to show a disappointing 2.4 per cent annual gain; the recovery that did not happen last year is now expected to happen this year; and so the percentage increase this year (now projected at 13.5 per cent by S&P Capital IQ) will be healthier thanks to starting from a lower base. There is ample room for disappointment.

How will this refract through markets? European stocks, evidently, have ignored 2014's disappointment and are keyed up for growth. US stocks have had little momentum this year, but still managed to set new records only a few weeks ago, and are up for the year.

This is startling, and driven by hopes that earnings will rebound sharply by the end of the year: the oil price will rise somewhat, while the benefits of cheaper oil will help consumer companies.

If an earnings recession does happen, it might not be quite such bad news as at first appears. Ned Davis Research points out that stocks rise more through such slow earnings growth periods than they do when earnings rise fast. Severe falls in earnings - as might happen this year - are an exception. But these have been driven by economic recessions (not on the US horizon) and falling revenues. Sales growth is sluggish, but not negative (outside the energy sector).

If this seems counterintuitive, put it in the context of the interest rate cycle. When the private sector is booming, rates tend to be rising, and this crimps the multiples it makes sense to pay for stocks. If profits this year are as bad as feared, there is every chance that the Fed would postpone rate rises until next year - which would be good for stocks.

There is, however, one fly in this ointment. Slow earnings growth does little damage to share prices, because investors expect it and take it into account in earnings multiples. With low multiples in advance, stocks can continue to advance as earnings growth slows, or even falls.

But price/earnings multiples are not cheap now. There are some arguments that they are not terribly expensive, but those arguments dissipate if earnings are actually to fall.

Put the macro confusion together with multiples that price stocks for perfection, and certainly not an earnings recession, and the risks are heavily tilted towards more volatility and a correction - even if lenient central banks limit the risk of a serious sell-off.

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