Albert Edwards Destroys The "Solid Earnings Growth" Myth
Not a day passes without some pundit opining on financial comedy TV how it is not the Fed but impressive corporate profit growth that is keeping the markets afloat. We can't help but laugh every single time. Why? Because with every reiteration, these pundits confirm they are clueless about just how it is that "profits" are created in the US - one way is from actual operations, another - from accounting gimmicks, especially when one includes the epic black boxes of bottom-line fudgery that are financials (and their tens of billions in quarterly loan loss reserve release "profits"). It is the latter (i.e., unbridled accountant imagination) that is the reason for profits "growing" at an impressive rate. As for actual earnings, when stripped away of all tangential one-time, non-recurring boosts, things are far, far worse. In fact, true earning growth matches the already abysmal growth pace of both revenues and cash flows.
But don't take our word for it: here is SocGen's Albert Edwards with the explanation.
US profits have begun to decline on a MSCI trailing basis – one of the key measures we monitor. We have long believed that the profits cycle is probably the most important leading indicator for the economic cycle as profits drive the highly volatile business investment component of GDP. The consensus believes that the US has just begun a long economic recovery, whereas we believe it is already quite advanced and vulnerable to events in Asia. Falling US MSCI profits are an extremely important straw in the wind that investors will ignore at their peril.
So what does the difference between reported and actual earnings look like? It looks like this:
My colleague Andrew Lapthorne published an update on the US profits situation in the wake of the Q4 reporting season. He writes "?At first look, growth in US net income last year looks remarkably good. With nearly all S&P 500 names having reported year-end figures, net income grew 14% last year, or 12.8% on an ex-financial basis. This is fairly impressive growth given the lacklustre economic backdrop. So should we be celebrating? Well we?re not so sure, as the source of this growth is not a robust improvement in operating cash flow, but is to be found in the large goodwill write-downs of 2012?."
Andrew then shows that the vast majority of this 14% growth in profits was driven by company-specific write-downs made back in 2012 ? with Hewlett Packard, AT&T and Verizon Communications leading the way.
And in chart format:
So what should one do if one wishes to get a sense of "clean" net income growth? Reading the following is a good start:
Most of the market tends to focus on profits on a pro-forma basis. We have never been big fans of this. These are the earnings numbers companies like to publish that steer attention away from the ?bad stuff?. My former colleague James Montier used to be highly scathing, describing them as “undefined, unregulated and untrue”. But because of their ready availability most in the market tend to quote pro-forma earnings numbers from the likes of Bloomberg and I/B/E/S and many base their equity valuations on this dodgy earnings metric. Yet even on this artificially inflated measure, trailing EPS grew only a paltry 5½% yoy in 2013, and 3% on a non-financial basis.
Andrew states that ?when looking at profit growth, a better profit series comes from MSCI. This definition of earnings is not as harsh as the S&P earnings definition incorporated into the likes of Robert Shiller?s cyclically adjusted PE (CAPE), but neither is it as overly generous as the pro-forma numbers supplied by I/B/E/S. To give you an example of the difference, during the 2009 profit slump S&P core earnings fell peak-to-trough by 92%, MSCI defined earnings fell by 55%, and I/B/E/S pro-forma earnings fell by 36%.
As we show above, not only are MSCI reported profits no longer growing, but the gap in thegrowth rate between these numbers and the pro-forma numbers is widening, with the proforma number considerably more ?optimistic?. ?This is a phenomenon that often precedes a more significant profit slump. It is also an indication that the quality of earnings is deteriorating."
What does all of the above mean? Simple: management teams realize that while the numbers presented for public consumption as pure BS, the true, unreported picture is far worse. And it is the "truth" that determines s management team capital allocation decisions, especially when it comes to deciding between buybacks, or a quick shareholder friendly sugar rush, and CapEx or business fixed investing, which is merely a confirmation that the corporate results are indeed accurate and the company itself foresees growth in the future. It is the latter which is the case, and is why CapEx has not only refused to rise - the biggest missing piece supporting a broad economic recovery and is why sellside strategists always "forecast" a surge in CapEx spending just around the corner - but why as income statement numbers continue to be fudged, CapEx will remain barely above the flatline, and as the economy slows further, is sure to contract, being the final missing link sending the economy into all out recession.
If MSCI profits are starting to fall then it?s more than just equity strategists who should be getting worried, for the growth in profits is closely associated with the business investment cycle
So where does this leave us? This cycle is already long in the tooth at 56 months and the resultant slowing productivity growth is beginning to impact profits adversely. While profits growth is so anaemic, any adverse shock such as an Asian currency devaluation that we have discussed previously (including both Japan and China), will be enough to deepen that profits recession and send US investment expenditure into decline. While most equity investors appear to believe that the US economy has reached escape velocity, a recession carries a far higher risk than the market supposes.
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