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Albert Edwards Destroys The "Solid Earnings Growth" Myth

Tyler Durden's picture




 

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.

Per Edwards:

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

His conclusion:

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.

Q.E.D(ead?)

 

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Tue, 03/25/2014 - 08:28 | 4589418 So Close
So Close's picture

If I was in control (i.e. one of the super rich) and wanted to maintain what I had to best of my ability without drawing attention to myself (i.e. getting sent to the guillotine) and new the country was screwed (i.e. had borrowed and promised way more than it could ever pay back) I would use my political connections (i.e. bought and paid for politicians) to simultaneously unleash a wave of distracting controversial public policy changes (i.e. gay marriage, attack on prayer in school, attack on the second amendment, attack on privacy and civil liberties) while creating as much inter-class warfare as possible (i.e. pitting a growing growing class of entitled civil servants (that I am not going to have to pay pensions for anyway (see i.e. 3 above)) against the shrinking middle class vs. a growing welfare class (see i.e. 3 above again) while using monetary policy (i.e. The FED, QE(ternity) ) to line my pockets as much as possible and use the proceeds to buy up as many hard assets (i.e inflation proof or at least resistant) as I could get my hands on.

Tue, 03/25/2014 - 08:38 | 4589453 Headbanger
Headbanger's picture

Oh gee,  Now who do we know that would ever do such a terrible thing??

Tue, 03/25/2014 - 08:49 | 4589492 CH1
CH1's picture

As long as CNBC et al keep up the propaganda, the muppets will keep believing.

That's what suckers do.

Tue, 03/25/2014 - 10:13 | 4589813 nickels
nickels's picture

People who don't have the practical skills to run an ant farm.

Tue, 03/25/2014 - 08:29 | 4589420 TideFighter
TideFighter's picture

I'll save you reading time: "Truth, in accounting, is a myth!"

Tue, 03/25/2014 - 10:03 | 4589674 philipat
philipat's picture

To paraphrase Leona, "Mark to market, On Balance Sheet and SarbOx are only for the little people"..

Tue, 03/25/2014 - 08:30 | 4589424 PlusTic
PlusTic's picture

Of course it's a myth, this is the greatest delusion in mkt hstory...what does that have to do with FED manipulation via HFT agents?  Stop trying to find cracks in the system, the system is a fraud as a whole.

Tue, 03/25/2014 - 08:41 | 4589463 Headbanger
Headbanger's picture

Yeah, wait and see how fucking scary it gets when the sheeple finally realize there is no system left at all now!

Tue, 03/25/2014 - 08:51 | 4589501 CH1
CH1's picture

Stop trying to find cracks in the system, the system is a fraud as a whole.

Yes!!  +10

Tue, 03/25/2014 - 08:31 | 4589428 PacOps
PacOps's picture

When we connect the dots it would be good to know where the dots precicely are to begin with.

Tue, 03/25/2014 - 08:46 | 4589488 Dr. Engali
Dr. Engali's picture

Profits don't mean shit to the market and they haven't for a long time. If they did we never would've had the.com bubble, and we wouldn't have.com bubble 2.0 right now. The only thing that matters to the market is that the free money keeps flowing. If that free money ever stops, then we will find a true floor in this market.

Tue, 03/25/2014 - 09:28 | 4589636 ElvisDog
ElvisDog's picture

Profits may not mean shit, but cashflow does. That is what the charts in the article are telling us - net positive cashflow is shrinking.

Tue, 03/25/2014 - 08:59 | 4589540 yogibear
yogibear's picture

Lowering expectations and beating them always seems to get great financial press as well.

Wall Street knows as long as the perception is up so is the money. No money movement, trading profits disappear. It's all about the delta.  

Tue, 03/25/2014 - 09:00 | 4589542 bdub2
bdub2's picture

fiddlesticks. All this fancy ciphering is for communist lovers. I'm gonna stick with most hated "recovery" wall of worry climbing, and unicorn skittle valuations of 15.5 p/e's for all. Moar on towards sp 2250!

Tue, 03/25/2014 - 09:18 | 4589590 laomei
laomei's picture

It's all business math, meaning, of course, it's all bullshit.  In an ideal world, it's simply a matter of "Assets - Debts" and "Income - Expenses", but of course, if you did it that way, most companies would be bankrupt.

Tue, 03/25/2014 - 09:27 | 4589631 ElvisDog
ElvisDog's picture

I listen to the Motley Fool podcast, not because they say anything useful but because they give me the Wall Street view of things. They love stock buybacks but never explain how a stock buyback improves the productive capability of a company. They never question how "earnings" seem able to rise by 15% when revenue only rises by 3%.

Tue, 03/25/2014 - 09:32 | 4589648 buzzsaw99
buzzsaw99's picture

...slowing productivity growth is beginning to impact profits adversely.

Translation: Layoffs aren't helping the bottom line as much as they used to.

Tue, 03/25/2014 - 09:51 | 4589716 mercenaryomics
mercenaryomics's picture

Question: What is the definition of MSCI profits compared to traditional accounting profit or economic profit? 

Google is telling me MSCI is "Morgan Stanely equity exposure indices" for emerging markets; so are we saying the failing MSCI indicates EM's are in trouble? 

Thanks.

Tue, 03/25/2014 - 12:51 | 4590520 The_Dude
The_Dude's picture

Yeah...little help....MSCI???  My Google-fu is off today...

Tue, 03/25/2014 - 17:22 | 4591777 Schmuck Raker
Schmuck Raker's picture

This is US data. MSCI is the company that massages the data.

http://www.msci.com/products/indices/country_and_regional/domestic_equit...

The article is about the US.

Tue, 03/25/2014 - 15:01 | 4591219 MrSteve
MrSteve's picture

Everybody in sales knows it is the big iron investments that drive the economy. Toothpaste and diapers are a distraction. The huge inventory in autos and ever-slowing sales at CAT tell which way the wind is blowing. Insider sales have been at least a brazilian times more than what insider buys have been, another fog horn sell sign. Maybe biotech and solar and darling momo stocks getting hit is also a clue. With Amazon P/E over 600, "investors" should be drinking doubles if they are still at the bar.

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