The First Two Weeks Of Earnings Season Are In. Warnings Ahead.

October 25, 2016

The First Two Weeks Of Earnings Season Are In. Warnings Ahead.

  • Don’t be fooled by earnings growth in financials and utilities. The underlying risks are growing too.
  • Lower margins are the first indications of a recession being around the corner. Global government and monetary stimulus make it impossible to know if one will be coming sooner or later.
  • Without buybacks earnings would be terrible.

The Earnings

The first two weeks of earnings season have passed and, according to FACTSET, the combined earnings released so far are better than expected but still negative. 23% of the companies in the S&P 500 have reported earnings and their aggregate earnings decline for Q3 2016 is -0.3%.

For now, this beats estimates as a 2% decline was expected, but it marks the sixth consecutive quarter of earnings declines. Apple Inc. (AAPL) and the energy sector will report earnings next week (Exxon and Chevron). The main drag to S&P 500 earnings is expected to come from there as both Apple and energy sector companies are expected to show large declines in earnings.

The sector that leads the earnings growth segment is financials with 7.8%, while utilities is in second with 6.8% earnings growth. When financials lead earnings growth in a slow economy it means asset prices are inflated. As far as utilities are concerned, low input prices enable them to increase their margins.

While these are the sectors with the best earnings growth, don’t rush into buying them as they are strongly influenced by business cycles. The best time to buy financials is the depression period of the business cycle. Financials are one of the motors that drive our economy and therefore they will always be around even if at some moments in time people think every financial company is doomed. That is always the best time to buy financials, especially the good, lower risk companies with less leverage and derivatives positions. The chart below clearly shows how the stock price of JPMorgan Chase (NYSE: JPM) is volatile and influenced by business cycles. The company will grow alongside the economy, but for extraordinary returns you should wait for darker skies.

Figure 1: JPMorgan Chase stock price. Source: Yahoo Finance.

Even more so than financials, utilities offer a product that is essential for the economy and for normal day-to-day life. Therefore, they are the certainty of your portfolio. Unfortunately, this certainty and stability has made utilities stocks similar to bonds. As interest rates go up, utilities go down. With the dollar strengthening on the base of expected interest rate increases, utilities have entered into a declining trend.

Figure 2: Utilities ETF (IDU) last 6 months. Source: iShares.

We’re not saying that utilities are a bad investment, but just that there is also a large risk for that 3% yield IDU offers at the moment.


Revenues aren’t usually a hot topic like earnings are, but they are also very important. Revenues have increased by 2.6% in Q3 2016 for the companies that have reported earnings.

Increasing revenues and declining earnings mean only one thing, declining margins. Declining margins mean that companies have difficulties achieving profitable growth. Such a point in the economic cycle indicates a saturated market ready for cleansing.

Market cleansing usually comes along as a result of a recession where the companies that have overstretched themselves with leverage and invested in low profit projects are forced to declare bankruptcy and leave more space for the more conservative players in the market who, once the economy rebounds, strengthen their market position. This doesn’t mean a recession will start tomorrow, but that a recession is close (next 4 years).

Global monetary and government stimulus can make an economic recovery last longer, but the economic laws are inevitable and sooner or later a recession will come along. Lower margins are the first indication. For now, only individual sectors are getting hit, like energy or restaurants where there have been three bankruptcy filings in October, but when the inflection point is reached, all sectors will be affected.


Buybacks have declined by 6.8% year-over-year but still have a big impact on earnings as 20% of S&P 500 companies reduced year-over-year share count by more than 5%. Buybacks have exceeded earnings for 137 companies and in the last four quarters, companies spent more than $580 billion on buybacks.

Figure 3: S&P 500 buybacks in millions. Source: FACTSET.

With buybacks being $580 billion in the last year and the S&P 500 market capitalization at $19.6 trillion, it’s easy to calculate the impact on earnings. By adding the $580 billion, or 2.9% back to the market capitalization, S&P 500 earnings would be lower by 2.8%. And this is just from adding the last 4 quarters of buybacks. By adding all the buybacks made in the last 10 years, we would get to a much worse result.

By owning an index like the S&P 500, you own a lot of companies that reinvest available cash flows into their own shares in order to improve their earnings per share. Higher earnings per share mean higher compensations for managers and an impression of higher stock prices. By owning individual stocks in the index, you can decide if you like what a company’s management is doing with your money or not. The two companies that did the most buybacks are Apple Inc. (NASDAQ: AAPL) and General Electric (NYSE: GE), but there is a big difference when doing buybacks at a PE ratio of 13.62 for AAPL or at a PE ratio of 21.24 for GE.

Buybacks are just another example of how earnings can be inflated at shareholders’ damage, so be careful when investing and analyze earnings.


The dollar is slowly getting stronger on the expectation of a FED rate hike.

Figure 4: Dollar index. Source: Bloomberg.

In the last three quarters, the S&P 500 enjoyed higher revenues and earnings due to a weaker dollar as the FED hasn’t continued to increase rates after the last hike in December 2015. In any case, a stronger dollar will make it more difficult to show revenue and earnings growth. If we estimate S&P 500 international earnings to be 40% of revenue, an increase of 100 basis points in the dollar index would mean 0.4% decline in revenues. It doesn’t look like much, but currencies are much more volatile than a 100 basis point move.


Earnings are on a good path to mark the sixth consecutive declining quarter despite a weaker dollar and low interest rates. Nobody has a crystal ball to predict what will happen, but the mixed signals described above indicate that the markets are approaching a territory where the risks are higher than the rewards.

Due to monetary stimulus and a high level of liquidity, the impact on stocks isn’t negative so there will be plenty of opportunities for good investment returns. Just be sure to look at the risks before investing in a company to check if they are growing organically or if their increased earnings are only a result of doing large buybacks by issuing debt.

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