That all the increase in risk assets has been on the back of multiple expansion for the past year is by now not news to anyone. What may come as a surprise to some who have not been paying attention, as Morgan Stanley conveniently reminds us, is that corporate profits have been declining not for one or two quarters, but for two full years now. "For net margins, March 2013 quarter-end results showed the top 1500 US equities at 7.15%, below the peak achieved in the June quarter of 2011. In fact, net margins have declined for the top 1500 companies every quarter since June 2011."
This is to be expected in a world in which underlying fundamentals continue to deteriorate and where the bulk of corporate activity focuses not on growth and expansion but on masking earning declines through the use of stock buybacks and levered dividends. Yet what has remained the same throughout this Fed-driven recovery (of the stock market, if not the economy), is the optimism surrounding the future. After all, if the the present is ugly, one has to at least project confidence and hope.
So how does the future look? The following several charts should summarize it quickly and painlessly.
First: the consensus forward EPS for the S&P - down, down, down.
[10]
But the constant "tapering" of optimism when it comes to fundamentals is only half the story. The other half is that these numbers would be even worse if the impact of stock buybacks was eliminated. From JPM:
The Divisor of the S&P500 Index is shown in Figure 5. This Divisor experienced a massive increase in the 1990s but started falling in 2004 due to strong buyback activity. Between 2004 and 2008 it fell by 7% or almost 2% per annual decline pace. It rose after Lehman due to large share issuance especially by financials and a drying up of share buyback activity. It started declining again in 2011 as share buybacks picked up. Since September 2011 the S&P500 Index Divisor is down by more than 2%.
The fall in the S&P500 Index Divisor has helped the earnings picture in the US. Had the Divisor remained constant since Q3 2011, the 4-quarter rolling S&P500 Operating Earnings-Per-Share would have only risen by $1.50 instead of the reported $3.70 increase. The S&P500 Operating EPS has risen from $94.60 in Q3 2011 to $98.30 in Q1 2013. Indeed studies have found that managers tend to increase share buybacks in periods of slow earnings growth to boost EPS via shrinking the denominator, i.e. the number of shares.
In other words, applying a 16x multiple to the $2.20 EPS boost from buybacks alone, means 35 S&P points comes from balance sheet jiggering alone.
But while optimism when it comes to corporate profitability has tapered to say the least, it remains just as buyoant in other areas. Such as profit margins where there is hope the recent two year reversal will finally, well, reverse again.
[11]
So a wholesale margin renaissance according to Wall Street desperate to justify bubble valuations: nothing new there either.
Ok we'll bite - how do companies feel about the future. Apparently, not so hot:
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Confused? Don't be: negative guidance preannouncements are at post Lehman highs. But why listen to companies when sellside research is always right.
But maybe we are missing something, and it is really a top-line growth story, with revenues poised to surprise to the upside. Well, no.
[13]
Sadly, there is no hope of a pick up in revenues either, which is perfectly logical: when companies don't invest in capital spending and future growth, this is the direct result.
Morgan Stanley admits as much: "If companies don’t invest in capital spending and research and development, they may maintain higher margins, but this lack of spending will not be a good catalyst for economic growth."
Alas, there is no economic growth, and in fact when stripping away buybacks, there would have been no EPS growth in Q1 either.
Which means that the only deus ex will have to be multiple expansion. The same forward multiple, by the way, which as we noted, is now higher than it was at the market's last all time highs back in 2007 [14].
[15]
But why worry: it's Tuesday, there is a POMO, the Yen is getting crushed again, and central bankers have everything under control. Just like they did back in 2007 when subprime and everything else was also "contained."
So best to just ignore reality and BTFD: because the Chairpriest said so.