Don’t Buy the Earnings Hype

Don't Buy The Earnings Hype

During my free time, I get to relive my teenage days with my 6-year-old son by playing Madden — probably the most popular NFL video game franchise ever.

I don’t know where he gets it from, but he likes to talk a lot of trash as we play.

To teach him a lesson, I’ll let him take a brief lead early in the game, which results in him taunting me about losing. Then, before halftime, I’ll take the lead and he’ll get upset.

It’s moments like this that he can learn a critical life lesson — don’t celebrate early.

A two-touchdown lead in the first quarter is meaningless if you don’t win the game. Likewise, a touchdown or interception early in the game is great, but he has to stay focused on the big picture. It’s about trying to win the game.

Right now, investors are celebrating an earnings season that seems to have topped meaningless analyst expectations. But there is a lot more to this story…

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If you’ve followed along this earnings season, you may have noticed a trend.

Most companies are beating bottom-line expectations. Topping these expectations is great, as it shows the company generated better-than-expected profits for shareholders. But those same companies are failing to beat revenue growth expectations, thereby missing a critical element to expanding earnings over the long term. In other words, companies are taking an early lead, but failing to win the game.

Without revenue growth, besting lowered earnings expectations does little to reassure me that our economy is thriving. And after delving further into recent earnings releases, I find the picture is even bleaker when looking at the months ahead. Let me explain.

The Real Earnings Story

Right now, we are more than three-quarters of the way through fourth-quarter earnings season. And we have a good idea of how it’s going to end up — and it’s not pretty.

According to FactSet Earnings Insight, nearly 70% of companies have beaten analyst earnings expectations. This is where the good news ends, and yet it’s what many investors are taunting us with — using it as evidence of a strong economy.

They fail to realize that underlying growth is determined by revenue, and that these figures are not manipulated like earnings are. If you want to get a feel for how the company’s operations are doing, you want to look at revenue growth. Here we find a different story.

Of the 76% of companies that have already reported, less than half have beaten revenue expectations. A stark contrast to the 70% that beat earnings expectations. But this isn’t the end of the earnings-season woes. They’re actually just the beginning.

There were 85 companies who provided first-quarter guidance. Of those, just 17 offered up positive earnings growth. A whopping 68 said they expected negative growth.

Even though the majority of companies beat tepid earnings expectations, we are still faced with a combined earnings decline of 3.7% for the fourth quarter so far. If that holds true for the remaining 24% of companies left to report — and I suspect it will — this will be the third consecutive quarterly decline in earnings on a year-over-year basis, and the first such occurrence since 2009.

As I pointed out previously, there are many ways to calculate an earnings recession. By some accounts, we have been in an earnings recession for over a year. But even with mainstream earnings reporting, where companies have manipulated and favorably adjusted their bottom lines, we are still seeing earnings fall for the third straight quarter.

Take Profits Now

What this means is that the Fed simply can’t continue to raise rates in 2016 … or in 2017 for that matter. A stronger dollar will put pressure on margins, pushing earnings even lower, and slowing revenue growth by reducing American exports.

Falling revenue and declining earnings also show that America’s economy is not as strong as it is being portrayed. If our economy was, in fact, expanding by more than 2%, generating a modest amount of inflation and boosting wages, we would need companies leading this charge to be more fundamentally sound. Until then, don’t expect to see any improvement.

As for what you can do, don’t celebrate too early.

If you are buying on the fact that earnings have topped analyst expectations and ignoring that earnings are actually declining 3.7% (and have done so for the past three quarters), then now is the time to take some profits off the table and prepare for better buying opportunities down the road.

Regards,
Don’t Buy the Earnings Hype
Chad Shoop
Editor, Pure Income