When you take all the fluff out of the markets, like artificially low interest rates and other easy monetary support from the Federal Reserve, we need to realize (at the end of the day) that stocks trade on a fundamental called corporate earnings. And going into 2015, as I’ll detail below, corporate earnings are weak at best.
Earnings Guidance Dismal, Growth Rate in Slump
As of December 12, 106 companies on the S&P 500 have issued guidance on their corporate earnings for this final quarter of 2014. Of these companies, 85 have issued negative guidance, while only 21 have issued positive guidance.
In other words, for every one company issuing positive guidance, there are more than four issuing negative guidance. Of all the S&P 500 companies, 80% that are issuing guidance for 4Q14 expect their earnings to be dismal. (Source: FactSet, December 12, 2014.)
Analysts are cutting estimates very quickly, too. At the end of September, for 4Q14, analysts were expecting corporate earnings for the S&P 500 companies to grow by 8.4%. This rate has now dropped to just three percent—a decline of more than 64% in estimates. (Source: Ibid.)
And the real problem is revenue growth—it’s just not there.
For the fourth quarter we are in right now, revenue for S&P 500 companies is expected to grow by just 1.4%. This is below the average of 3.5% over the last three years…telling me that American companies aren’t able to sell more.
Earnings Delusion & Trickery
As real earnings and revenue growth is a struggle, companies resort to stock buyback programs to push per-share earnings higher—a grand illusion.
In the third quarter of 2014, S&P 500 companies spent $143.4 billion on share buybacks—up 16% from the same period a year earlier. On a trailing 12-month basis, S&P 500 companies spent $567.2 billion on share buybacks, representing an increase of 27% year-over-year. (Source: FactSet, December 16, 2014.)
In the third quarter of this year, an astonishing 75% of the S&P 500 companies bought back their shares!
Here’s just one example of how share buybacks give investors a false impression:
For the first nine months of 2014, International Business Machines Corporation (NYSE/IBM)—a component of the Dow Jones Industrial Average—reported net income of $6.44 per diluted share. In the same period a year ago, this company reported net income of $9.27. Looks like IBM’s earnings declined by 30.5% on the surface. (Source: International Business Machines Corporation, October 20, 2014.)
But digging deeper, we find that in the first nine months of this year, IBM reduced its share count by 8.6%—from 1.11 billion shares to 1.01 million shares outstanding. If IBM didn’t purchase any of it shares, its earnings per share would be $5.88 per diluted share in the first nine months of 2014, a decline of 36.5%. With the help of its stock buyback program, IBM essentially improved its earnings per share by 16%.
Dear reader, I can’t stress this enough: the only thing that’s keeping key stock indices alive is the Federal Reserve. For some time now, my belief has been that the easy money policies of the Fed have supported the stock market. And stock buybacks are one way that has happened—by keeping interest rates artificially low for so long, public companies have been able to borrow billions of dollars on the cheap to buy back their own shares and support their market valuations.
If the S&P 500 is already trading near a record-high price/earnings multiple of 20.08, while corporate earnings are growing at only three percent (supported by stock buyback programs) and revenue growth is only 1.4% (a less manipulated number), how can stocks continue to move higher?
The stock market bubble will burst. It is only a matter of time.
About the Author - Michael Lombardi, MBA at Profit Confidential, a daily publication for Lombardi Financial customers. (EconMatters author archive Here)
The views and opinions expressed herein are the author's own, and do not necessarily reflect those of EconMatters.