Corporate Earnings Growing 17% in Q3? No Way! Rather Slowing Sharply to At Most 8.5%
Nouriel Roubini | Oct 31, 2006
One of the recent mysteries about the US economy is the question of how come reported corporate earnings (say for S&P500 firms) have been growing so rapidly when GDP has decelerated so fast from 5.6% in Q1 to 1.6% in Q3. Part of the answer could have been the sharp increase in the share of profits in GDP that we have experienced in the last few years but the just reported 17% growth in earnings in Q3 for S&P500 firms seems too large compared to the 1.6% growth of the economy.
The answer to this puzzle has come out today in a note ("Corporate earnings- Are they really running in double-digits?") by David Rosenberg, the chief US economist for Merrill Lynch and one of the few Wall Street economists who has written serious and detailed bearish analyses of the economy. With his estimated probability of a recession in 2007 now possibly as high as 80% Rosenberg could even be taken as being even more bearish than me (as my subjective probability of a recession is still 70%).
Regarding corporate earnings, Rosenberg shows that the 17% earnings growth figure for Q3 is meaningless and misleading - compared to Q3 GDP growth of 1.6% - for several reasons: it isa year-on-year growth measure while GDP is a quarter-on-quarter annualized measure; it is distorted by the fact that in Q3 of 2005 earnings fell because of the Katrina effect; it is distorted as it is a earnings per share (EPS) measure; it does not correct for seasonality. Once Rosenberg appropriately adjust the data, actual seasonally adjusted annualized growth of rate of earnings in Q3 was only 8.5% not 17%. And if you were to make an inflation adjustment, real earnings would be growing even less than 8.5%. Not only is earnings growth much lower than the 17% headline figure but it path in the last few quarters is showing a sharp deceleration: in Q4 of 2005 annualized earnings growth was almost about 19%; it decelerated to about 16% in Q1 of 2006 and to about 14% in Q2; and it has now sharply fallen to 8.5% growth in Q3. This is a very sharp deceleration of earnings growth that is very consistent with the sharp deceleration of the economy in 2006.
Going beyond the excellent analysis of Rosenberg, note also that, among the S&P500 firms, a large fraction of the earnings growth in 2006 has come from energy firms and financial sectors firms; outside these two sectors earnings growth is significantly lower. Moreover, given the recent sharp downward revisions of profits in national income accounts for Q1 and Q2, it must be the case that earnings growth outside the S&P500 companies is even worse than that of the ex-energy and financial earnings of the S&P500 firms.
So, there is no mystery. The economy is sharply slowing down and earnings growth is sharply falling. These revised lower measures of earnings growth are also consistent with the "investment strike" of the US corporate sector: why firms have been investing so little in new real capital spending if their earnings growth is so rapid as the headline figures allege? The reality is that the corporate emperor has no clothes or it is at least half naked: earnings growth is rapidly slowing down and it will fall further in Q4 and 2007 as the economy spins into a hard and ugly recession. And, as I have analyzed before, in an a typical recession the S&P500 falls by an average of 28%. So, the end of the sucker rally is getting closer. The recent bombardment of bad macro news on Q4 in the last two weeks has definitely broken the momentum of US equities in the last week; the myth of a Q4 growth rebound - after a dismal Q3 -is now rapidly fizzling away. Wait for a few more indicators and the sucker rally will melt faster than you can watch it.
NOTA para los que no saben inglés. El autor discute la evolución de los beneficios en las empresas de EEUU. Las que cotizan en el SP500 (un índice mucho más amplio e interesante que el Dow Jones). Las últimas referencias indicaban un crecimiento de los beneficios anualizados en el 3T de 2006 del 17%. Sin embargo, el panorama no es tan bonito como lo pintan. Cuando se corrigen los datos y se extraen los beneficios achacables exclusivamente al trimestre se observa una fuerte desaceleración de los beneficios hasta el 8,5% en 3T 2006 desde un 19% en el 4T de 2005. Por tanto, los beneficios de las empresas se están ajustando a la deceleración de la economía americana como sería de esperar.
El autor opina que lo peor está por llegar y anticipa (en otros artículos) una fuerte corrección bursátil para finales de año o principios del año que viene.
Veremos si Roubini sigue teniendo razón. Lo importante es que no es el único en opinar así y que algunas de las grandes firmas de la banca de inversión hacen análisis similares.