Q1 Earnings Risky for Stocks

The highly-anticipated first-quarter earnings season is in full swing, with traders eager to see how US companies are faring.  While expectations are low, these profits releases still collectively pose serious risks for today?s overvalued and overextended US stock markets.  A few high-profile misses could prove all it takes to unleash a long-overdue serious selloff.  Investors and speculators alike need to remain wary.

Most publicly-traded companies report their comprehensive quarterly financial results in the month after a calendar quarter ends.  This deluge of reports released in a matter of weeks is called earnings season by traders.  And it?s exceedingly important, as underlying corporate profits are the ultimate fundamental driver of stock prices.  Supported by earnings, they can only climb over the long term if earnings grow.

Shares of stock represent fractional ownership stakes in underlying corporations.  And the way they are valued in the marketplace depends on their future earnings streams.  The larger the ongoing profits any company earns, the higher its stock price will be.  While bouts of popular greed or fear can temporarily disconnect stock prices from underlying corporate profits, ultimately stock prices are slaved to earnings.

And this underway Q1?15 earnings season isn?t looking pretty.  As April dawned, Wall Street estimates for overall corporate earnings growth for the elite stocks of the flagship S&P 500 stock index (SPX) had just crumbled to -4.6% year-over-year!  This was a wild swing from the +5.3% analysts had expected back at the start of Q1 in early January.  It was the sharpest drop in earnings expectations since way back in Q1?09.

While Q1?15 SPX earnings expectations have improved slightly to -4.0% as of this week, that is still a major decline.  A variety of factors are being blamed.  The parabolic US dollar blasted 8.9% higher in Q1, a massive rally.  This is a big drag on earnings with about half of the elite SPX component companies? sales coming from outside the US.  The stronger dollar makes US goods and services more expensive abroad.

And that lowers demand and sales.  Energy companies? profits have collapsed too.  While crude oil only fell 12% in Q1?15 compared to plummeting 41% in Q4?14, quarterly-average oil prices still collapsed by 50% YoY.  This gutted oil companies? profits, which are traditionally a bastion of earnings strength within the SPX.  Cold winter weather and the West Coast port shutdown also contributed to the slumping profits.

Stock bulls argue that the first quarterly drop in corporate earnings since 2009, just after that once-in-a-century stock panic, is no big deal.  It?s only projected to be a 4% decline they say, and they believe the factors that are driving it are transitory.  The US dollar isn?t going to rally forever, oil?s not going to fall forever, and winter and the port shutdown are over.  They expect corporate profits to rebound later this year.

Only time will tell if their 2015-profits optimism is justified.  I have my doubts though.  Wall Street firms and their stock analysts get paid based on assets under management.  So they have huge financial incentives to always stay bullish on stocks, since they want to convince their customers to keep their capital fully invested.  Analysts? future earnings estimates are almost always too rosy, perpetually being revised down.

All the groupthink exuberance about the US-corporate-profits outlook also seems to fly in the face of the long parade of weaker-than-expected economic data in recent months.  As a whole, corporate profits are ultimately constrained by the growth rate of the broader US economy.  If it continues sputtering along, or makes a turn for the worse, there?s no way SPX companies? full-year-2015 earnings will meet estimates.

But the greatest risk posed by deteriorating corporate earnings swirls around today?s wildly-overvalued US stock markets.  While a 4% annual profits decline may be digestible in fairly-valued stock markets, it could very well cause today?s exceedingly-expensive ones to choke.  Earnings are at the very core of stock-market valuations, the denominator of the all-important price-to-earnings ratio that measures them.

Historically P/E ratios were always considered conservatively in trailing-twelve-month terms.  That looks at current stock prices divided by the last full year?s, effectively the last four quarters?, actual corporate profits.  These trailing results are hard data set in stone, there is nothing ambiguous about them.  By that classic TTM P/E metric, today?s prevailing stock prices are dangerously expensive as you will soon see.

Wall Street fears scaring investors away with well-justified valuation worries, so it avoids talking about trailing P/Es like the Black Death.  Instead it fabricates a pure fiction known as the forward P/E.  While the P is still the current stock price, the E is analysts? estimates of the next four quarters? profits.  Those are not only nothing but guesses in a volatile world, analysts are notoriously wrong in predicting the future.

Their optimism is boundless, driven by intense pressure from their employers to convince investors to stay fully deployed in stocks to maximize Wall Street?s hefty percentage-of-asset-under-management fees.  So the earnings estimates that feed into fictional forward P/Es are almost invariably too high.  Of course this means the relatively-low forward P/Es Wall Street constantly cites really underestimate true valuations.

This forward-P/E cult has become so dominant that these days whenever you hear about P/E ratios on CNBC they are always going to be forward estimates.  Historically, P/E ratios were always assumed to be classic trailing-twelve-month P/Es.  Since estimates vary, forward P/E ratios do too.  But the number I see most often today is around 17x.  Wall Street claims the SPX component stocks are trading around 17x earnings.

Compared to the century-and-a-quarter historical average US-stock-market valuation of 14x earnings, 17x certainly doesn?t sound extreme.  Stocks are on the expensive side based on future estimates, but not excessively so.  But this picture changes dramatically using actual trailing earnings.  Today the 500 elite SPX component stocks are collectively trading way up near 26x earnings, ominously close to 28x bubble territory!

Whenever I write about these dangerous overvaluations, I get tons of pushback from skeptics.  They all wonder how I can claim 26x while all the mainstream sources they see claim 17x.  The answer is simply the difference between hard historical trailing-twelve-month earnings and ethereal guesses on the future.  But since today?s rampant overvaluations are so important for traders to understand, here?s our exact methodology.

At the end of every month, we capture the stock prices, conservative trailing-twelve-month P/E ratios, dividend yields, and market capitalizations of every S&P 500 component company.  In those rare cases where P/E ratios exceed 100x, we cap these outliers at 100x to minimize their distorting impact.  Then we average all 500 of these individual SPX-component P/E ratios, both simply and weighted by their market capitalizations.

This process is very simple and easy for anyone to replicate in a couple hours.  Build a spreadsheet of the S&P 500 component companies, grab their TTM P/E ratios from Yahoo! Finance or Google Finance, plug them into the spreadsheet, and average that column.  The result is shown in this chart, data that Wall Street is desperately trying to distract investors from seeing.  Stock valuations are exceedingly high today!

The light-blue line is individual SPX-component TTM P/Es averaged, and the dark-blue line weights them by individual companies? market capitalizations.  Market-cap weighting helps ensure the overall index P/E isn?t skewed by smaller companies less representative of investors? actual holdings.  Either way, today?s stock-market valuations are crazy-high as of the end of March just before Q1 earnings season.

In simple-average terms, the elite S&P 500 stocks were trading at a staggering 25.9x earnings!  And in market-cap-weighted-average terms, their collective P/E wasn?t much lower at 24.0x.  These levels are dangerously high.  Once again 14x is historical fair value for US stocks.  21x is expensive, and twice fair value at 28x is hyper-risky bubble territory.  Valuations are actually close to that with earnings deteriorating!

Corporate profits are rolling over and starting to fall at a time when stock prices are as overvalued as they have been since the early 2000s.  As earnings retreat, the E in P/E will slide which will ratchet up overall valuations.  That ?mere? 4% projected drop in Q1 profits from the SPX components that Wall Street is claiming is no big deal would push valuations up to 27.0x earnings!  That ought to terrify prudent investors.

Stocks get expensive at just 21x on a trailing-twelve-month basis.  Provocatively the last cyclical stock bull that peaked in October 2007 crested at an SPX P/E of 23.1x in simple-average terms.  That resulted in a subsequent cyclical bear that mauled the SPX 57% lower in 1.4 years!  While that particular one culminated in an ultra-rare stock panic, cyclical bears typically cut stock prices in half after cyclical bulls.

Overvalued stocks, combined with stock-market cycles, are the major harbinger of bull-market toppings and imminent bear markets.  Not only can SPX valuations scarcely get more extreme than today?s lofty levels, but the stock-market cycles are extreme too.  This magnificent cyclical bull has blasted the SPX 213% higher in 6 years, far beyond the average of a doubling in less than 3 years.  It is very long in the tooth.

On top of that, it?s been an astounding 3.5 years since the last 10%+ correction in the SPX!  In normal healthy bull markets, such essential sentiment-rebalancing major selloffs happen about once a year or so on average.  So the US stock markets have rarely been more overvalued or more overextended, right at the first time corporate earnings are contracting since soon after 2008?s stock panic!  This presents serious risks.

With the SPX way up near 26x earnings on an average trailing-twelve-month basis, a lot of institutional money managers who understand today?s actual valuations are nervous.  They know that stocks are really expensive, but they can?t sell and risk lagging behind their peers? performance until they have a good reason to.  And a handful of high-profile misses on Q1 earnings could provide their necessary justification.

Earnings seasons past have proven that major companies falling short of expectations can spark sharp selling.  This is even true in stock markets that aren?t overvalued and overextended.  Given how weak the overall US economy is, and the howling US-dollar headwinds, the odds are high that some subset of first-quarter results is really going to disappoint in the coming weeks.  Traders need to remain wary.

Today?s dangerous valuation extremes are the direct consequence of the Fed?s third quantitative-easing campaign that ramped up in early 2013.  Before that, this cyclical stock bull was righteous.  Check out the chart above again.  Even though the SPX rallied dramatically in the initial years after the stock panic, valuations remained stable and even retreated.  That signaled that corporate earnings were actually growing.

But since early 2013, valuations have shot straight up pacing the stock markets.  The Fed?s QE3 debt monetization and associated jawboning ignited a huge artificial stock-market rally that wasn?t supported by underlying corporate earnings.  It was pure multiple expansion, P/E ratios inflating because stock prices were rising far faster than profits.  This sharp increase in valuations only moderated a bit last year.

And that certainly wasn?t because corporate earnings started catching up with stock prices.  Instead US corporations took advantage of the Fed?s heavily-distorted debt markets to borrow cheap money and buy back their stocks.  SPX-component-company buybacks soared to $553b last year, the highest since 2007.  That was up 16% from 2013 and about four times 2009?s levels!  That?s an incredible $46b-per-month rate.

That debt-fueled buyback binge reduced the number of outstanding shares, and thus the denominator of the earnings-per-share equation which is the P/E ratio?s E.  So not only are today?s valuations extremely high, but that?s even after being lowered by financial engineering rather than growing businesses.  The Fed?s upcoming rate-hike cycle, the first in 9 years, is almost certainly going to garrote this stock-buyback boom.

With the unsustainable buyback pace on the brink of rolling over, the downside risk to these extremely overvalued and overextended stock markets is even higher.  Today 14x fair value for the SPX based on its components? average TTM P/E is way down around 1200, a staggering 43% lower than today?s levels!  The next bear market, an inevitability in the forever-cyclical markets, will maul stocks back down under fair value.

And the coming high-profile misses in this first-quarter earnings season could very well kick off that selling.  Even if the shrinking earnings are centered in energy stocks, the overall market downside risks are still serious.  Energy stocks traditionally have lower P/E ratios than the general stock markets, as investors are never as excited about commodities as they are about hot sectors like technology.  Those low P/Es are history.

There?s an oil-stock index known as the XOI, and the big majority of its stocks (the US-based companies) are also SPX components.  At the end of March before this disastrous Q1 earnings season, these XOI components already had an average TTM P/E of 21.8x.  Just a year ago in March 2014, it was 14.8x.  So energy-company valuations are already rising on plunging profits, and this will only worsen after their Q1 results.

The normally-low energy-stock valuations help offset the lofty tech-stock valuations within the SPX, so rising energy-company P/E ratios will really force up the overall SPX valuation.  Wall Street will do all it can to try and mask this.  Another trick it uses to blind investors to overvaluation is aggregation.  Instead of looking at individual-SPX-component P/Es, it adds all their earnings together to look at as a single number.

These total earnings are divided by the SPX?s level to get an index P/E.  But aggregation is very misleading.  A handful of companies with huge profits like Apple can mask poor earnings and high P/Es in many dozens of other SPX companies.  Aggregated P/E ratios are even worse when they are figured on a fictional forward-earnings basis, which Wall Street analysts do constantly on CNBC these days.

In light of all this, the downside risk posed by high-profile earnings misses is as high as it?s ever been this earnings season.  Investors and speculators alike need to remain on guard, and ready for a long-overdue selloff.  This can be gamed with SPY, the flagship S&P 500 ETF.  Investors can hedge their long holdings with SPY puts, and speculators can bet on SPX downside with SPY puts or outright SPY shorting.

With valuations extreme and market cycles long overdue to reverse, cultivating an essential contrarian perspective has rarely been more important to investors and speculators alike.  If your only sources of market information are mainstream, you are going to miss the reversal warning signs because they won?t be reported.  All you will hear is the usual stocks-to-the-moon cheerleading, which will cloud your judgment.

We can help at Zeal, as we?ve long published acclaimed weekly and monthly newsletters for contrarian speculators and investors.  You can harness our decades of hard-won experience, knowledge, and wisdom, as well as ongoing research, to help you thrive in these risky markets.  Our newsletters dig deep to explain what?s really going on in the markets, why, and how to trade them with specific stocks.  Subscribe today!

The bottom line is this first-quarter earnings season now underway poses great downside risks to these lofty stock markets.  Overall corporate earnings are actually expected to fall for the first time in 6 years, even by the Pollyannaish Wall Street analysts.  This deterioration is happening at a time when stock-market valuations are already dangerously high, actually extreme on the classic trailing-twelve-month basis.

And not only will lower profits force these valuations even closer to bubble territory, but today?s stock markets are super-overextended and distorted thanks to the Fed?s epic manipulations of recent years.  It?s not only been far too long since a major selloff to rebalance sentiment, but most traders don?t even think one is possible anymore.  This makes for a ripe environment for earnings misses to unleash serious selling.