In his latest Global Strategy Report, Albert Edwards at Societe Generale discusses “earnings season” which he calls “cheating season“.
We have always found that swings in analyst earnings expectations mirror the economic cycle quite well, but because of the weekly frequency, swings in analyst earnings optimism often act as a timely leading indicator for the economic cycle. If that is still the case, the recent data for the US should be worrying. Despite the soothing Q3 headline earnings reports as US companies ‘game’ the system, all is not well once you look into the ‘MUC’ (Manipulated Underperforms Conservative).
Remember the so-called Fed model? We were told that the extraordinarily high PEs were justified by low bond yields. The key plank of the Ice Age theory was that this positive correlation would break down and that equities would de-rate in absolute and relative terms compared to government bonds thereby inverting the close positive correlation between bond and equity yields.
What this also means is that in an Ice Age world, the equity cycle will more closely correlate with economic and profits cycles. Most correlation analysis finds virtually no post-war relationship between economic growth and the stock market.
But, this does not hold true during the Ice Age. Indeed, we knew from Japan that the equity market would start to track the economic and earnings cycle closely.
In the Ice Age, equity investors need to pay close attention to economic and earnings cycles and not be comforted by lower bond yields. If that is the case equity investors should be getting nervous NOW as earnings optimism starts to fall away sharply.
Earnings Upgrades vs. Downgrades as Percentage of Changes
We have long believed that the US reporting season should in fact be called the US cheating season as companies game the market to ramp earnings down ahead of company announcements only to beat analysts estimates by 1¢ on the day!
Apparently companies believe the feel-good news headlines of a earnings beat will offset the negative impact of downward guidance ahead of the report. In fact the evidence suggests otherwise: my colleague Andrew Lapthorne has shown that those companies that engage in earnings manipulation underperform those that do not. He developed a very useful MUC Score, Manipulated Underperforms Conservative.
(An update of the MUC is being delayed while Andrew works on an update of a more comprehensive earnings quality score, formally called the cheating, or C-score. Developed by my former colleague James Montier, Andrew changed the name as companies got mighty shirty when they appeared on this list!)
I rely on Andrew for this timely weekly data which he highlights every Monday in the Global Equity Market Arithmetic.
This week, he notes that “despite being in the US reporting season, which typically delivers manufactured surprises and therefore an improvement in US earnings momentum, we have been surprised by the complete lack of a bounce in upgrades versus downgrades. Not only has there been zero bounce, but next year’s expectations continue to be downgraded with 65% of all estimate changes to 2015 currently coming through as downgrades. Meanwhile European earnings momentum has also collapsed. Hardly an inspiring environment for pushing equities further upwards.”
US Earnings Momentum
European Earnings Momentum
We need to be watching this weaker than expected earnings optimism data closely. Certainly the front page chart shows the apex of weakness globally is in the US and it is entirely plausible that the deflationary winds blowing around the world are washing up on US shores with the situation worsened still by the stronger dollar. A sharp decline in EPS optimism since 2009 has been consistent with previous hiatuses in financial markets. In other words, there may be more to the recent flash-crash than just one weak retail sales datum a deeper malaise surrounding weak profits may be driving events.
Is Your Favorite Company Cooking the Books?
In addition to his own excellent analysis, Albert linked to Montier’s C-Score: Are your favourite stocks cooking the books?.
To help decide, Montier came up with six questions. The answer is binary: yes or no.
- Is there a growing divergence between net income and operating cash-flow? Management has less flexibility to alter cash flow, whereas earnings can be stuffed for all sorts of “funnies”.
- Are Days Sales Outstanding (DSO) increasing? If so (i.e. accounts receivable are growing faster than sales), this may be a sign of channel stuffing.
- Are days sales of inventory (DSI) increasing? If so, this may suggest slowing sales, not a good sign.
- Are other current assets increasing vs. revenues? As some CFOs know that DSO and/or DSI are usually closely watched, they may use this catch-all line item to help hide things they don’t want investors to focus upon.
- Are there declines in depreciation relative to gross property plant and equipment? This guards against firms altering their estimate of useful asset life to beat earnings targets.
- Is total asset growth high? Some firms are serial acquirers and use their acquisitions to distort their earnings. While this may be justified in some circumstance, generally it has been shown that high asset growth firms underperform.
Does It Work?
As a shorting tool, Montier suggests using the C-Score in combination with some measure of over-valuation. This was on the basis that high-flying and generally more expensive stocks that are tempted to alter their earnings in order to maintain their high growth status. He used a threshold price to sales ratio of 2 and found that this drove the absolute return down to -4% in both the US and Europe!
Mike “Mish” Shedlock