This is going to surprise many of you, but the corporate results season in the US is not nearly as good as media headlines and daily broker comments would suggest. While more than three quarter of profit releases is beating consensus forecasts, the end result is that earnings expectations in the US are falling.
Yes, you read that correctly. Earnings forecasts in the US are falling. As a matter of fact, the ratio between upgrades and downgrades for US companies this year has not been as low as in July. So much for the Grand Illusion that corporate profits are showing investors the way forward into a new bull market upswing.
As far as I can tell, the main reasons for the negative trend in US earnings forecasts are: the persistent failure by most companies to match profit surprises with sales surprises, ongoing cautious to dim outlooks by company CEOs, a persistent slowing of economic momentum showing up in economic data plus a general belief that US corporate profits are peaking on many measurements.
The fact that earnings expectations are falling is in itself unlikely to stop US equities from extending their July rally into August, as improving technicals and sentiment remain the leading factors, but ultimately no rally can ever be sustained without solid support from earnings forecasts.
To put it simply: rising share prices and falling expectations both undermine the “value on offer” proposal put forward by bullish stockbrokers, but in opposite directions. This could potentially lead to a rapid narrowing of the present valuation gap, which in turn could push equities from “too cheap” into “expensive” rather quickly.
The good news is: so far earnings forecasts are falling at a modest pace. The not so good news is: the pace in downgrades has accelerated in July as illustrated by the fact that upgrade/downgrade ratios have now fallen to their lowest level – not just in the US, but virtually across all major regions, including Asia.
I have been following the trend in earnings forecasts in Australia closely this year (I always do). Thus far my observations in Australia have matched observations by others elsewhere. Between February and June average earnings per share growth forecasts for ASX200 companies fell from 6% to less than 4%, but over the past month they have fallen further to less than 1.7% for fiscal 2010. This clearly shows a similar negative acceleration taking place in Australia.
It doesn't take a genius to figure out where this acceleration comes from: from Macquarie ((MQG)) to Austar (AUN)), to Programmed Maintenance ((PRG)), to Harvey Norman ((HVN)) and Woolworths ((WOW)) Australian companies have either disappointed ahead of the August results season, or they have been forced to guide investors towards lower expectations.
Again, this is not a 100% negative story. So far, expectations for fiscal 2011 are still for a solid 18.5% increase in average earnings per share in Australia. But let's not get too carried away either, the big bulk of this jump in profits relates to energy and resources companies.
The average EPS growth forecast for industrial companies in Australia is around 13%. In comparison, BHP Billiton ((BHP)) is still expected to grow EPS by 61% in FY11, Rio Tinto ((RIO)) is expected to grow EPS by 16% in 2011 and Woodside Petroleum ((WPL)) is projected to improve EPS by 45% in FY11.
The Big Four Banks are on average expected to improve EPS by 14.3%, but the differences are pronounced. National ((NAB)) sits on top with an expected growth rate of 19.3% while Westpac ((WBC)) is clearly falling short with expected 7.9% growth only.
On current forecasts, all these companies look “cheap” and “good value”, as illustrated by the gaps between broker price targets and share prices, even after a stellar performance in July. But what if market expectations continue falling?
This seems but a valid question given widespread views that market expectations ran up too high when the global economy seemed on fire up to April, but now that overall momentum has turned weaker the expert expectation is that a downward adjustment has become necessary. This is why the August results season should answer many lingering questions.
Thus the next 4-5 weeks should see earnings expectations fall further in Australia. Is this a problem? On my calculations average EPS growth forecasts have to drop by 6.5% to put the ASX200 on an FY11 earnings multiple (otherwise known as Price-Earnings Ratio) of 14, the long term average.
Such a fall may not seem much in the light of this week's adjustments to forecasts for Macquarie and Programmed Maintenance, but for the market average this would seem a bit much. Unless, of course, we would see a dramatic fall in prices for crude oil, copper, iron ore and the likes (not expected at this stage).
Within this framework, it will be interesting to see how much exactly will be shaved from current profit expectations. And then the next important factor will be whether those expectations can then finally start rising again – or at least stop falling.
If we assume current EPS expectations remain unchanged (which is rather unlikely) then the ASX200 won't reach its PE ratio of 14 before it reaches well above 4800 (4844 to be precise). But if we assume a loss of 2% growth then a PE of 14 equals the index at 4747 – around 200 points away.
As I have pointed out in the past, the present gaps between average target prices for the big banks and the two big diversified resources companies suggest more upside potential, as these gaps, with the present exception of CommBank ((CBA)), are larger.
There is one major caveat in all of the above and that is there is no certainty whatsoever that earnings expectations will stop falling post August. As a matter of fact, if global economic momentum remains weak this quarter, chances are this won't be the case.
The question then arises as to how much longer earnings forecasts will continue falling, and how much exactly we should expect in terms of cuts and downgrades? After all, at 1% in lost EPS growth representing circa 50 points for the ASX200 index, there doesn't seem to be a big margin left for investors.
This is exactly why some of the more bearish market commentators suggest that equity investors are currently ignoring the underlying trend in earnings forecasts at their own peril. If global economic momentum continues to deflate away throughout Q3 and Q4 this year, earnings forecasts will continue falling. The end result should be obvious.
One of such commentators is Societe Generale's Albert Edwards, one half of the Montier-Edwards duo that briefly gained rock star status in 2008-2009 because of their accurate predictions for global equity markets' weakness due to the GFC.
Edwards remains one of today's Super-Bears, predicting a new Ice Age for the US economy with economic momentum expected to continue slowing into 2011. The current rate at which global earnings expectations are falling already suggests the US is heading for a new recession, says Edwards.
Closer to home, market strategists at BA-Merrill Lynch also believe the continuous falls in global earnings forecasts are a bad omen for equity markets later this year. Tim Rocks and his team believe, similar to Edwards, that earnings expectations will simply continue falling month after month from now on. Eventually, of course, the investment community which is now oblivious will be forced to pay attention.
But even the less bearish inclined market strategists at Citi are warning their clientele about too rosy earnings projections in Australia. Citi believes, for example, that many analysts have been too positive on what can be achieved in terms of corporate cost savings.
It is for this reason that Citi anticipates August will see many companies sticking to cautious guidance for FY11 operational profits. This in itself could see further acceleration in lowered market expectations.
Maybe the key take-away message is not that August will bring more downgrades to earnings expectations, but the fact there will be winners whose forecasts will rise, and losers whose forecasts will fall.
Citi suggests sectors most likely to remain among the winners are miners, media and retail companies, while construction and utilities should end up on the losing side. On a company specific level, Citi predicts there will be many more losers than winners over the coming four weeks.
The stockbroker's short list of candidates likely to surprise in a positive manner consists of Cochlear ((COH)), Computershare ((CPU)), Centennial Coal ((CEY)), Ansell ((ANN)), Foster's ((FGL)), AGL Energy ((AGK)), Telstra ((TLS)), UGL ((UGL)), Boral ((BLD)), Seek ((SEK)) and Amcor ((AMC)).
Maybe this is the real take-away for the upcoming results season: there will be winners and losers, but the division between both groups might turn out more significant this time than during the past two result seasons.
Don't hesitate. Choose wisely.