Have You Seen the Elephant ?: More on Earnings
Seeing the elephant is an old phrase borrowed, I think, from the British Army and used by many armies now and refers to one's first experience of something new and shocking. In their case combat - which is about as shocking as it gets. Fortunately our experiences aren't going to be on anything like that level. But still the Elephant here is learning that for the first time the old linkage between GDP, Profits and organic economic growth appears to be frayed to the breaking point (Dr. Pangloss Treating Goldie: Markets, Profits & Earnings, The Heart of the Matter: Profits vs Earnings ? ).
But first a small confession. My early religious training was in economics and after spending several years as a novice and then a few more in monastic retreat (otherwise known as grad skul) I went apostate and joined the real world. Now economics would tell us that any industry or product that gets a large return/profit must be serving someone somewhere. Yet as the share of Financial companies in profit has gone from 10% to 20% to, in just the last few years, 30% I begin to find myself turning into a modern Physiocrat. They were some of the earliest formal economists and started with the argument, in late 18th C France, that the only true source of wealth was Agriculture. Given the structure of the economy at the time they had a point if not a case. But other sectors like trade, manufacturing and finance were important contributors who's outputs made the functioning of the agricultural sector more efficient - thereby raising overall output and producitivity. Nonetheless I still find it difficult to believe that Finance contributes so much to the effective functioning of the economy that a 30% share of returns is warranted. Oh well...
Back to the Elephant and this time we'll go to the central cathedral of capitalism the Wall St. Journal - specifically it's recent reporting on quarterly profits and earnings. Which, BTW, they report as net operating income, NOT EPS !
If you take a look at the accompanying charts we have a third view, albeit on a shorter timeframe, of
the shares of the various industries. Here we see quarterly profits from Q205 to Q207 in absolute and relative terms. Take a look for yourself and see what interpretations you come up with.
For the life of me there doesn't appear to be any major acceleration in profit growth that would cause me to be wildly excited about business performance. Earlier (Models, Metaphors, Musical Chairs and Market Outlook) we'd looked at the markets and even quoted BigPicture from last Fall about the range-boundedness thereof. Based on these charts we'd have to argue that was a pretty sound judgement by Mr. Market.
On both absolute and relative basis we also don't see much to argue for a great outlook for any industry or sector. Energy and Materials looks pretty flat as do Consumer related industries (green-shaded) and Industrials/Utilities. Even Tech/Telecom, other than the spectacular performance of a few select (NDS, QQQQ) firms undergoing major innovation shifts (APPL, GOOG come to mind) indicate anything arguing for the runup over the other general or sector indices. Granted there was improvement in '06 and so far in '07 but an acceleration ? Nah.
Again we come, from yet a 3rd but consistent, data source that profit growth is a) NOT organic and b) neither acclerating nor indicating likely future growth.
Earnings, at least in headline reported EPS numbers, is another matter entirely. Or is it ? One "final" pass at a 3rd data source - S&P's quarterly earnings numbers.
Looking at the accompanying chart, low and behold, the S&P numbers surprisingly (at least to me) line up almost exactly with the National Income data and the WSJ quarterly numbers. In other words earnings have grown but not by that much, they appear to be flattening off recently and the DON'T appear to be growing at a rate that would indicate higher markets. BtW - these are EPS for the SP1500, not the SP500 !
So we come full circle on four different but complementary data sources: GDP accounts, National Income accounts, quarterly Operating Income and reported earnings. With the economy slowing into a growth recession, with Housing much worse than anticipated and likely to still be worse yet over the next two years and with problems with asset pricing and valuations in the credit markets one would have to conclude that the outlook is not very sanguine :).
Too namby, pamby a conclusion ? Try this - there is NO indication that a better outlook for earnings is based in any reality I can investigate. Yet the Markets and Wall St. maintain a very upbeat outlook. Puzzling indeed, isn't it ? Feel free to chime in - variant opinions would be welcome.