Listening to Wall Street analysts, or their financial press cheerleaders, one would be left with the impression that earnings season has been gangbusters, and the recent 2-3 quarters of growth are sure to lay the basis for a new golden age in which EPS rises at double-digit rates for years to come. There are just a few problems with this wildly incorrect conclusion. First, after a year of earnings recession and a year in which earnings went nowehere, 2017 is finally catching up to where analysts said earnings would be two years ago, and that only due to a record liquidity and credit injection by the "developed" central banks and China.
Meanwhile, even as recent EPS growth has been strong, it was only due to a "base effect" as a result of a plunge in year ago earnings following tumbling Energy profits. As for the future, good luck to those double-digit gains in 2018.
There is another problem: as we discussed yesterday, despite the so-called coordinated global recovery, the difference between GAAP and non-GAAP continues to be 10% or higher.
This is what we said last night, as per the latest Factset data:
For Q3 2017, the average difference between non-GAAP EPS and GAAP EPS for all 21 companies was 284.1%, while the median difference between non-GAAP EPS and GAAP EPS for all 21 companies was 10.1%. The average difference between non-GAAP EPS and GAAP EPS for the DJIA was unusually large in the third quarter because of Merck. The company reported non-GAAP EPS of $1.11 and GAAP EPS of -$0.02 for the quarter. Thus, the percentage difference between non-GAAP EPS and GAAP EPS for Merck for Q3 exceeded 5000% (on an absolute basis).
So let's normalize: excluding Merck, the average difference between non-GAAP EPS and GAAP EPS for the remaining 20 DJIA companies was 15.8%. How does that number look in context: Over the past six quarters, the average difference between non-GAAP EPS and GAAP EPS for companies in the DJIA was 72.8%, while the median difference between non-GAAP EPS and GAAP EPS was 13.4%.
So if one wants to avoid the "fluid", easily adjustable concept of earnings altogether, and focus on something far more tangible, such as cash flow, what is the conclusion? Well, as SocGen's Andrew Lapthorne points out this morning, this emerges as yet another problem to the strong earnings growth narrative, as not only has cash flow growth stalled, but excluding energy and financials (i.e., eliminating the base effect), it is now the lowest in 4 years, since late 2013. From SocGen:
The US yield curve (10s-2s) continues to head lower, yet headline trailing EPS growth for the S&P 500 is around 10%. However, much of this strength relates to the rebound in the Energy sector. The chart below strips out Financials and looks at the annual change in Gross Cash flow post the Q3 reporting season. What is noteworthy is how ex Energy growth has slowed markedly since October last year. For all the fanfare of the Q3 reporting season gross cash flow growth is back down at anaemic levels and contrasts with much of what we read.
Earnings reality aside - if only for the time being - even as various market indices continue to grind higher to new all time highs, the amount of turbulence below the surface is rising. Indeed, as Lapthorne adds, "while on the surface equities continue to exude calm, scratch beneath the surface and there are increasing signs of stress." He explains:
European equities, for example, were down 1.4% last week and the Eurozone is down almost 3.5% in euro terms since the beginning of the month. Japan, which is amongst the better performers over the last month, has seen high levels of intraday volatility with the daily spread exceeding 1% on four out of five days last week.
And noweher is the recent "shadow volatility" more visible, so to speak, than in the world of heavily indebted companies. Picking up on his warning from a week ago, in which Lapthrone showed why US balance sheets are far worse than they appear, and warned that "this doesn't end well", today he doubled down by looking at the underperformance of heavily indebted companies in both Asia and Europe, to wit:
We have regularly commented on the diverging performance in the US equity market between stocks with strong balance sheets versus those with weak balance sheets. This made sense to us, given the higher levels of corporate debt raised in the region in recent years and a Fed that is tightening. However it would appear that this theme is now spreading. Puneet Singh highlighted today how balance sheet risk is increasingly a factor in the performance of China A shares and we show below that this aversion to risk is now manifesting itself in European equities. In large part, this recent move has been beta (risk on/off) driven by high volatility stocks dropping 4% in Europe over the last nine days. However stocks with a bad balance sheet score (which incorporates a volatility metric) have fallen 200bp more. Beware bad balance sheets everywhere.