Wither Earnings?

Earnings season is just beginning, and low equity volumes and bland price action indicates a lack of interest, or at least conviction. A theme that increasingly interests Macro Man and, judging by his email box, some of the more astute researchers out there, is the seemingly inevitable sharp downgrade of US earnings expectations, which would presumably lead to lower stock prices.

While consensus expectations have been marked lower, they still imply stronger SPX earnings in 2008 than in 2007. How that squares with an inability to procure credit and a nascent shedding of labour is an issue that has frankly eluded Macro Man. What we can observe is that the gap in 12 month trailing earnings and the 12 month forward forecast has widened sharply recently. Now, part of this is the simple mechanical function of the forward "earnings year" shifting from 2007 to 2008...though even smoothing for that suggests a wedge is forming between trailing earnings and the forecast.
Even more remarkably, analysts are forecasting stronger 12 month forward earnings now than they were a year ago. To be sure, the degree of optimism has waned considerably from its peak of a few years ago. But observe that in the last two recessions, y/y forward estimates turned sharply negative, reflecting the substantially lower profit base resulting from the economic downturn. On this metric, there is very substantial room for pessimism to increase and downgrades to emerge.
And if the SPX looks vulnerable to revisions, what about the less-covered small caps? Data is admittedly hard to come by here, and Macro Man is working with the scraps that he can retrieve from Bloomberg. (Any readers with good historical data on Russell trailing and forecast P/Es and who is willing to share, by all means contact Macro Man by email.)

But as the chart below indicates, trailing earnings in the Russell have collapsed over the past couple of quarters, which has pushed the trailing P/E up to nosebleed territory (53.3 according to Bloomberg.) But the earnings estimate data that Macro Man has been able to procure hasn't really budged at all.
If there's room for futures disappointment in the S&P, what should we be expecting for the small caps? Yesterday's survey of US small business confidence plunged to the lowest level in the history of the survey, which goes back to the mid-80's. Hardly a ringing endorsement of the small companies that represent the backbone of the US economy, is it? The large cap/small cap trade that Macro Man tracked in the blog portfolio has taken a step back over the past few weeks, as major indices have taken a breather and nudged higher. If the disappointment which appears to be forthcoming actually does materialize, both the SPX and especially the small caps look vulnerable.
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Anonymous
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April 9, 2008 at 12:06 PM ×

What happened to blog portfolio?

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April 9, 2008 at 12:08 PM ×

Hi MM, this is one of my favourite trade, but watch BBG and instead to compare P/E between SPX and RTY, compare P/BV or P/Sales or P/CF and you'll find a really different result.
But I really don't understand if these measures are correct and why these differences?
Maybe rate of growth of earnings?? but I'm not an analyst..
any help?
Fabio

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"Cassandra"
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April 9, 2008 at 12:38 PM ×

In regards to MacroTrading Ideas sugestion, the problem with comparing indices in general, and an index to itself over time is that the differences are often dramatic with respect the sector composition (between indices) and the composition of the index itself over time. The S&P 500 undoubtedly looked different with bifurcated performance and weights c2000, and energy & commods rep subdued, than it does today with roaring energy market caps and JDSU, NT etc. at 5 cents on the dollar of the prior hundred billion dollar market caps. With financials having reported large neg quarters and years, this was the primary reason for dramatic falls in historic index earnings.

To make the differences in other measures really meaningful, one needs to find a way to normalize each component relative to itself and aggregate that by cap weights. For by way of example if energy is now the largest component with a greater weight than historical norms and measures and is trading cheaper than other sectors making the index look cheaper, but is more expensive in comparison TO ITSELF than its ever been, one runs the risk of misconstruing the implications. Of course one can do the "7-Minutes Abs version of the analysis and you might get lucky, but there is an inherent risk of playing with toys that one doesn;t fully understand or comprehend.

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April 9, 2008 at 1:32 PM ×

Cassandra, thanks for your good reply.
Watching spx i see that biggest sector is Integrated Oil and Gas with a 7,9%, then pharma at 6,1% and then others with really lighter weights. Also into russel2000 there's a oil sector that is doing new highs, but i can't find the weight..
So best trade maybe is to be long spx, long oil, short russel2000.
MM what do you think about??

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Macro Man
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April 9, 2008 at 1:58 PM ×

I personally prefer a narrower "long" than the SPX...namely, the megacaps that can continue to derive benefit from half-decent foreign growth/the weak dollar for another few quarters...until the inevitable lags kick in. In the blog portfolio I had the OEX (S&P 100) as the long side of the short Russell trade.

As for oil, I dunno. The biggest company in just about every index in the world is an oil company...so I'd be more inclined to buy low delta puts on oil.

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RJH Adams
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April 9, 2008 at 8:52 PM ×

Hi MM.

Bloomberg had a piece today about analyst forecasts being badly off in q3 and q4 respectively. Maybe this is extrapolation overweighting the recent past and overlooking the cyclality of margins. Maybe they are victims of the forecasting cult we operate in.

Either way, competition and a souring macro view are bringing what have been low rate-primed and probably always unsustainable margins back towards mean.

However, I do think that the recognition process is seriously two-paced. Anecdotally (I admit it)there are unmistakable traces of chewing and spitting upon small cap equity that have so far not been inflicted elsewhere to the same degree.

What comes next may justify those levels which otherwise look like overshoots. But I can't help feeling the two track split is partly a function of the sheer amount liquidity in the hands of institutional money which is going towards propping up their natural, larger company territories.

Obviously a judgement on institutional macro sentiment for now...

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Hedge Thing
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April 10, 2008 at 9:11 AM ×

Hi Macro Man - interesting stuff, as ever, from you and your correspondents. John Authers wrote a similar piece in the FT on April 1st, with similar conclusions. I took a stab at applying it to key Asian indices (+ some in Japan & the West) and then took it further to see which markets may have already priced in slowing earnings into NEXT year and screened it using (really) simple PEG=1 type analysis. ie For a relative call in global equities, which markets were already forecasting a deceleration in earnings growth AND were priced at a PE/Growth ratio of under 1. Results were surprisingly positive for SPX and NDX. (I was expecting SERIOUSLY negative.)
What do you think... make sense to look at it this way?

(http://hedgething.blogspot.com/2008/04/street-over-optimism.html)

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Macro Man
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April 10, 2008 at 1:20 PM ×

Rawdon, I've observed that small caps have been caned more (relative to large caps)in the US than in the UK or Europe...which I suppose is fitting, given relative domestic demand (though one could posit that the UK should start drastically underperforming.)

Hedge Thing, interesting analysis, though I would be interested in seeing the aggregate earnings growth estimates for '08 and '09 relative to '07 as a means of sorting. I struggle to see how the SPX is conservative, and thus bullish (given aggregate estimates for something like 65-70% earnings growth), and Japan optimstic/bearish with essentially flat expectations. I understand what you're trying to do with the '09 delta, but I don;t think you can not mark 2008 to market.

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