A Major Tailwind Is Fading
A major tailwind is fading... This chart says an 'earnings recession' could be just around the corner... The buyback backlash begins...
Regular Digest readers know it's been one of the biggest tailwinds for stocks over the past few years...
Despite growing risks in the credit markets, U.S. corporate earnings – and more specifically, corporate earnings per share ("EPS") – have been on a tear.
After declining for seven consecutive quarters in 2015 and 2016, EPS of companies in the S&P 500 soared by double-digit percentages for seven straight quarters through September 2018. And with roughly half of the companies in the S&P 500 reporting fourth-quarter 2018 results to date, that streak almost certainly extended to an eighth consecutive quarter to end the year.
Unfortunately, we're unlikely to see a ninth...
Wall Street analysts are now forecasting EPS could decline this quarter for the first time in three years. As the Financial Times reported on Monday...
Consensus estimates point to a 0.8% drop in earnings per share this quarter, according to FactSet, a dramatic markdown from a forecast of 3.3% growth at the end of December. If expectations prove true, it would be the first such contraction since the second quarter of 2016.
Concerns about earnings growth in 2019 surfaced last year and the outlook has continued to darken as the reporting season for the fourth quarter progressed...
[Corporate] tax cuts boosted profitability last year, setting up less flattering comparisons for 2019. What is more, the U.S. has endured brutal cold snaps of late and companies have had to contend with the uncertainty of the longest government shutdown in U.S. history.
Falling analyst estimates aren't the only reason for concern, however...
The following chart compares the S&P 500's EPS growth with "earnings revision breadth." This is simply a measure of how many companies are cutting earnings guidance for future quarters versus how many are raising guidance. When breadth is falling, it means more companies are issuing negative guidance than positive.
As you can see, this measure is highly correlated with earnings growth with a 26-week (six-month) lag. And right now, it suggests we're on the verge of the biggest decline in corporate earnings since the 2008-2009 financial crisis...
In short, one of the biggest tailwinds for stocks could soon become a significant headwind.
Speaking of EPS growth...
Regular readers also know that a big part of this trend had nothing to do with rising corporate profits. Instead, as we've discussed many times, it was fueled by a huge boom in debt-financed share buybacks. As my colleague Mike DiBiase noted most recently in the November 28 Digest...
Buybacks are hugely popular among CEOs and CFOs of publicly traded companies for two reasons...
For one, they increase a company's earnings per share ("EPS") without any increases in earnings. By reducing the number of shares outstanding, management can increase EPS without any changes at all to its profits. It's accounting magic.
Let me give you an example... Say a company called Acme Corporation has $2 million in annual earnings and 1 million shares outstanding ($2 in EPS). Acme management buys back 200,000 shares of its stock the following year, so there are now 800,000 shares outstanding. If earnings remain the same, the company's EPS jumps 25% to $2.50 per share without anything else changing ($2 million in earnings divided by 800,000 shares).
This is important because EPS is one of Wall Street's favorite financial metrics. Companies are often rewarded with higher stock prices when their per-share earnings jump. Buybacks make meeting – and beating – Wall Street's estimates much easier.
That leads to the second reason why executives love share buybacks: A huge part of their compensation is tied to their companies' stock prices... Top executives earn millions of dollars with bonuses and stock options tied to EPS and share prices. In other words, they have plenty of incentives to buy back their shares quarter after quarter.
While buybacks are great for executives, they're often terrible for ordinary shareholders...
Under most circumstances, buybacks only make sense when the company's shares are cheap. Unfortunately, that is rarely the case in practice. More from that Digest...
The following chart compares the value of the S&P 500 Index with stock buybacks of the companies in the S&P 500 since 2002. You can clearly see that companies buy back the most shares at market peaks, when stock prices are most expensive. Those are, of course, the worst possible times to buy back shares. They did it in 2007, and they're doing it again today – and with even greater intensity...
In fact, companies are on pace to spend more on buybacks this year than on capital expenditures for the first time since 2007. In other words, instead of investing more in capital projects that will benefit shareholders in the future, corporate executives are using buybacks to make themselves richer.
Even worse, many companies have been compounding this mistake by loading up on huge amounts of debt to pay for these buybacks.
For now, the 'party' continues...
Companies spent a record $770 billion on share buybacks last year, according to Goldman Sachs analysts. And they are currently projected to spend another $940 billion this year.
But we're already seeing signs that the "hangover" could be a doozy. As the Wall Street Journal reported last night...
At least five declared or likely Democratic presidential candidates want to restrict how much stock U.S. companies can buy back from shareholders, raising the chance a common tool used by public companies and relied on by investors could become an election issue...
The practice has drawn criticism from those who contend buybacks amount to financial engineering to boost share prices and executive bonuses; others say the practice shortchanges the economy by directing back into the stock market funds that could have gone directly to workers. Proponents of share buybacks argue that they can unlock unused cash for investing elsewhere.
The latest salvo came in a Sunday op-ed in the New York Times by Senate Minority Leader Chuck Schumer (D., N.Y.) and Mr. Sanders of Vermont. The two plan to propose legislation that would force public companies to provide higher wages and more robust benefits for workers as a condition for launching buyback plans.
New 52-week highs (as of 2/4/19): BioTelemetry (BEAT), Cameco (CCJ), Essex Property Trust (ESS), Kirkland Lake Gold (KL), and Procter & Gamble (PG).
In today's mailbag: More on the "bull vs. bear" debate, and kudos from two longtime subscribers. Send your general questions, comments, and complaints to feedback@stansberryresearch.com. Good or bad, we read them all.
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"It could be worse I suppose... they could really throw in the towel and start cutting rates again. That would be akin to the final horn going off on the markets." – Paid-up subscriber R.H.
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Regards,
Justin Brill
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February 5, 2019