CHARLIE FELL SERIOUS MONEYThe debt-fuelled economy is in recession, input costs are rising and exports are slowing
NINETY-SIX years since the White Star Line's Titanic sank to the bottom of the Atlantic Ocean, America's supposedly unsinkable General Electric (GE) has struck an iceberg.
Relative calm seemed to have returned to Wall Street as the current earnings season got under way despite disappointments from both Alcoa and United Parcel Services but the tranquillity proved short-lived as the usually reliable GE missed consensus estimates for the first time in almost four years and, more disturbingly, by a surprisingly wide margin. Earnings dropped 12 per cent year on year and the 44 US cent a share reported fell seven pennies shy of analyst expectations.
The conglomerate's poor performance was broad-based and not confined to financial services. Not surprisingly, the stock responded to the news with its largest daily percentage decline since Black Monday in 1987.
Nevertheless, Wall Street's elite continue to forecast double-digit gains in profits for corporate America in 2008. They will be proved wrong. The second longest earnings expansion enjoyed by corporate America over the past half-century came to a halt during the third quarter of last year. Diehard bulls believe the downturn will be over by the end of the summer but such optimism is based on fantasy rather than fundamentals.
A more realistic assessment suggests that corporate profits will continue to decline through the remainder of the year and the cumulative drop in earnings could easily be as much as 20 per cent and perhaps even more.
The current profit cycle saw return on equity and profit margins soar to levels that are well beyond historical experience. Despite the disappointing performance in recent months, return on equity remains well above long-term averages while margins exceed historical experience by three percentage points.
Furthermore, current earnings relative to 10-year averages are at their highest level in almost 60 years and at a level that has been exceeded just three times over the past century. Needless to say corporate profitability has suffered in the years following such high readings - with or without an economic slowdown - as the increasing number of competitors attracted to excess returns leads to mean reversion. Historical analysis shows that margins and returns drop well below trend during a downturn. Unfortunately, such analysis suggests that corporate profits could drop by 40 per cent.
Top-down analysis corroborates the negative view on earnings. The debt-fuelled economy is in recession, input costs are rising and the export sector - the supposed saving grace - is slowing. The corporate sector is inextricably linked to the economic cycle and, when nominal GDP is sustained at 4 per cent or below year on year as seems certain through 2008 and 2009, revenue growth slows and profit margins decline, leading inevitably to an earnings downturn.
Corporate America's good fortune in recent years has been built on a concerted effort to reduce variable costs - both operating and financial - and incremental revenue increases dropped straight to the bottom line. Unfortunately, operating and financial leverage works both ways and the factors that drove profitability higher have now reversed.
An earnings downturn has begun. Some argue that price/earnings multiples have dropped to historically attractive levels but historical comparisons should be ignored as they typically span a period of no more than 20 years. The limited sample is not statistically significant and artificially inflates the average price multiples used for comparison as the data set includes the bubble-era valuations of the late-1990s. It is hardly surprising that stocks look cheap when value is assessed relative to the most expensive valuations in US stock market history. The valuation errors are compounded by comparing price multiples on estimated one-year forward earnings to historical averages computed on 12-month trailing earnings. Once again, stocks appear to be trading at attractive levels with a price multiple of less than 14 times forward earnings versus the historical average multiple based on trailing earnings of 17 times.
However, an historic valuation multiple based on realised one-year forward earnings reveals that stocks are not cheap after all, trading only slightly below the average price/earnings ratio of 14 times and, if profits follow their typical pattern and drop by more than 20 per cent, stocks are priced at close to 20 times, which can hardly be described as cheap.
It is worth noting that stocks traded on less than 15 times realised one-year forward earnings at the end of 1989 just months before an economic recession struck.
The credit crisis rolls on but investor focus has returned to fundamentals as the earnings season unfolds. Some continue to remain optimistic and call for double-digit growth in 2008.
However, astute investors should heed the words of Warren Buffett who warns: "You pay a very high price . . . for a cheery consensus."
