Philly Fed Points To Weaker Profits Ahead
The media has been busy today flashing up charts showing the percentage of companies that have beat earnings estimates so far this quarter. Still very early in the earnings season roughly 81% have managed to best expectations so far. This sounds incredible until you realize two things. First, earnings' estimates were drastically lowered from a 10% expected growth rate in October to less than 1% just before earnings' announcements started. Without this massive decline in estimates the number of companies not beating estimates would be near 100%.
Secondly, the majority of companies are only able to beat estimates using accounting gimmickry such as Bank of American and Morgan Stanley. Bank of America took a $3.3 billion adjustment to Fair Value Obligations without disclosure, which smells very fishy, and a $1.5 Billion DVA adjustment. Together 28 cents were added to the net income line in order for BofA to reach the 31 cent EPS number. However, in terms of real revenue there wasn't actually much to speak of despite the media arm waving. Morgan Stanley today was not much better as there earnings included $2 Billion of DVA which would have wiped out all of their gains. The point here is that if we go back to reporting earnings based on GAAP accounting, as used to the be the requirement, the current run of earnings would be far less exciting.
However, what does that have to do with the Philadelphia Fed Manufacturing release this morning? It is all about pricing pressures. The sharp decline in the index, which is due to the fading of the warm winter weather effect as discussed yesterday, showed the majority underlying sub components weakening. One area that we watch particularly closely is net prices. This is simply the difference between the prices paid and the prices received. As shown in the chart, this indicator has only eclipsed 30 on the index a few times in the past. Each previous peak in the net prices index was a precursor to a subsequent decline in corporate earnings as profit margins was squeezed by higher input costs and a lower ability to pass them through to the end consumer.
Without all of the "accounting magic" that riddles companies income statements' these days — it is very likely that we would not have the sharp ramp up in earnings post the 2008 recession. The repeal of mark-to-market accounting for banks, revenue accounting schemes to apply revenue that is yet to be received and a variety of other quirky measures have led to the massive resurgence of earnings. The problem, however, is that they are not quality earnings in many cases and will do little to support companies' prospects during the next economic recession.
The decline in the net-prices index is something that we need to be watching closely. While companies are currently crawling across near zero earnings growth estimates — the reality is that any economic weakness at all will quickly push those earnings negative in the coming quarters ahead. This will in turn lower valuation assumptions for stocks bringing prices down. We are very long into the current cycle and while analysts continue to expect higher levels in future quarters and years ahead historical cycles tell us a far different story