LOM Weekly Perspectives

Earnings growth expectations

Accounting shenanigans aside, U.S. corporate profits are indeed recovering. This is a normal phenomenon that occurs when economic activity picks up -- as it has been doing. So no surprises in this regard. At the same time, the more ebullient forecasts of strongly rebounding profits have had to be revised downward. Pleasant experience of consistent double-digit gains in the nineties had attuned investors to a repeat performance in the early years of the twenty-first century, after a normal cleanup period following the bust in 2000. Also, the usual crowd of cheerful folk on Wall Street had, until recently, continued to make fairly rosy predictions, based more on hope than reality. Nor was the Fed averse to fuelling optimism.

Well, the performance of the markets in recent months shows that there are a growing number of doubters regarding a super profits rebound. Meanwhile, despite the hopes of the perma-bears, there has never been any sign of exhaustion or panic selling by the mass of investors. Really, there is no sound reason for a big sell-off. People have been willing to hang on to valuations in expectation of a good earnings-growth outcome. In fact, the revision of expectations has been gradual and reluctant. Ultimately, either earnings prospects had to meet or exceed expectations, or valuations had to adjust to be consistent with more modest results. Alternatively, investors can bank on a waiting period until earnings growth catches up to valuations.

When a long-term investor buys the stock of a company, that person is, of course, paying a sum up front, in expectation of a stream of future earnings. That stream of earnings has a measure of uncertainty associated with it, which constitutes risk. A smart investor makes the right calculations and does not overpay for the stock. Normally, if circumstances change, the security should be re-priced accordingly. In theory, the market, being the collective wisdom of all investors, would always correctly value securities and mark them down when real prospects deteriorate. In practice, this sort of efficient rationality does not always apply and prices can diverge from their intrinsic worth. Also, when a bubble forms, market prices can swing way out of line. In addition, valuations can become distorted by inappropriate fiscal and monetary policies.

Producing double-digit earnings growth consistently, year after year, is very difficult to do for most companies. The late nineties was an exceptional period in which excessive capital spending generated a virtuous circle that was very conducive to profit growth for a multitude of corporations. And if that didn't produce the desired results then the combined forces of corporate management, accounting firms and Wall Street investment banks were ready to engage in enough deception to cook up the sort of numbers that would please investors. Admittedly, the latter were more than willing to be convinced. Earlier this year, when a stream of revelations came out about all kinds of lying and manipulation, investors didn’t run for the exit and were disposed to overlook the unpleasantness. Instead, they decided to wait for signs of the reappearance of strong earnings growth, not worrying too much about how the figures were produced. Now, the realisation is setting in that, however you manipulate it, sustainable earnings-growth numbers will be more modest than previously expected.

Based on the experience of previous economic recoveries the market's behaviour, this year, has been unusual and disappointing. Those who averaged historical data, and forecast a sustainable rally, have found the past to be a poor guide to actual market performance. However, current circumstances and conditions have been different and have, naturally, produced different results. In addition, many people have ignored the importance of the changing relative risk of different asset classes. During the good years, the risk premium on equities had been whittled down substantially, under the assumption that risks of holding stocks had undergone a structural decline. Well, now, with the renewed realisation of inherent equity risks, investors are paying greater attention to risk premiums and demanding a better overall spread relative to other asset classes. In other words, the price paid for stocks, given earnings prospects, must be low enough to generate returns that compensate the investor for the higher risks that they assume. Otherwise, on a risk-adjusted basis they may be better off holding other assets.

The struggling stock market has given rise to concern among some observers that it is predicting substantial economic weakness ahead. But this is not necessarily the implied outcome. As we have argued above, the revaluation is all about a revision of expectations regarding optimistic earnings-growth projections -- not a forecast of sharply deteriorating conditions. Of course, it is not impossible that the market correction will overshoot on the downside, in which case it may initiate a self-fulfilling process. In such a case, consumers and firms will rein in their spending, subsequent to a sharp fall in equity markets, resulting in still further weakness. However, this is currently a low-probability scenario.